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HomeMy WebLinkAboutStaff Report 6428 City of Palo Alto (ID # 6428) Finance Committee Staff Report Report Type: Action Items Meeting Date: 12/15/2015 City of Palo Alto Page 1 Summary Title: Fiscal Years 2017 to 2026 General Fund Long Range Financial Forecast Title: Fiscal Years 2017 to 2026 General Fund Long Range Financial Forecast From: City Manager Lead Department: Administrative Services Recommendation Staff recommends that the Finance Committee review, comment, and accept the Fiscal Year 2017 to 2026 General Fund Long Range Financial Forecast and forward the Forecast to the City Council for acceptance. Executive Summary The Fiscal Year (FY) 2017 to 2026 General Fund Long Range Financial Forecast (LRFF), which marks the beginning of the FY 2017 budget planning process, projects a slight General Fund surplus of $0.1 million in FY 2017, a shortfall of $0.6 million in FY 2018, and surpluses in the remaining years of the Forecast. Although economic indicators and rebounding tax revenues reveal that the City of Palo Alto has reached a turning point from the Great Recession, this Forecast reflects financial obligations and rising benefits costs that diminish the positive outlook over the next 10 years. Despite improving revenue receipts as projected forward, the City continues to face challenges related to the funding of infrastructure, the desire to retain and attract a talented workforce to be responsive to the City Council and the community, rising benefits costs, and unfunded long-term pension and retiree healthcare liabilities in the amount of $439 million. Additionally, as an alternative Forecast Model shows, the City needs to prepare for the next recession. While the base model captures the past 20 years of compounded revenue annual growth rates, which includes economic booms and recessions, staff included the alternative model for further discussion. While recessions are difficult to predict, history shows that one will be experienced during the term of this Forecast. In June 2014, the City Council approved the Infrastructure Plan in the amount of $125.8 million. Since approval of the plan, the City was able to dedicate additional funding to close the initial funding gap of $7.5 million and fund the related public art expenditure of $1.1 million, and a small Infrastructure Plan Reserve of $0.8 million. However, as discussed during the Council Infrastructure Plan Study Session on December 9, the projects identified in the Infrastructure City of Palo Alto Page 2 Plan are estimated to cost substantially more due to updated designs, rising construction costs, and the State imposed requirement to pay prevailing wages. Some of these higher costs will be funded through higher than previously estimated Transient Occupancy Tax receipts dedicated to the Infrastructure Plan. Over the ten years of the Forecast, the additional funding for Infrastructure is estimated at $68 million. Since the Great Recession, the City Council has approved various strategies to mitigate the rising cost of salaries and benefits. These strategies include: (1) employees paying their own CalPERS contribution (between 6 percent to 9 percent of salary) except for the members of the Fire Chiefs’ Association; (2) sharing future health plan cost increases; (3) creating a second pension tier (and the state implemented a third tier effective January 1, 2013); (4) reducing professional development expenses; (5) cost of living freezes for four years; and (6) terminating the Variable Management Compensation Plan. Continuing with previous actions to curtail the growth of benefits costs, in 2014, as part of approving the agreement with SEIU and the compensation plan for Management and Professional employees, the City Council approved the cost sharing of future health plan costs. Currently, the City is in negotiation with all of its bargaining groups. It is the City’s desire to retain and attract a talented workforce. Therefore, this Forecast includes salary and benefits adjustments based upon projected cost of living increases and market changes. This Forecast provides a long-term view of the City’s General Fund to provide a strategic focus for addressing future funding needs in the FY 2017 Proposed Budget and beyond. This Forecast assumes FY 2016 service level remain the same. As in past years, the Forecast has been updated based on current information compiled from various sources, in addition to utilizing available tools to project revenues and expenditures. This document facilitates City Council members’ and staff’s understanding of the long-term impacts of past decisions and identifies issues that must be addressed in the near and long- term. The Forecast is not a prediction or a commitment of resources; rather, it is a reasonable snapshot of the City’s future financial condition based on various assumptions and currently available data. A continuously improving economic climate is noted by the majority of national, state, regional, and local economic indicators. This Forecast assumes a continued, gradual growth of the national economy with positive impacts to the local economy, which is reflective in the estimates of economically sensitive revenue estimates. It is important to note that consistent with previous forecasts, the methodology for calculating changes for out-years of the Forecast (FY 2017 to FY 2026) are based on a historical analysis of increases using the Compounded Annual Growth Rate (CAGR) with adjustments factored in for known items. By using the historical average growth rate that incorporates the up and down cycles over the past 10 or 20 years, there is no single year in which a downturn is depicted. Instead, past downturns (e.g. dot com bust and Great Recession) have been factored into the compound growth rate used to forecast future revenue streams. Staff performed a reasonableness test of the results and made appropriate changes to the CAGR analysis. City of Palo Alto Page 3 As shown in the table below, the FY 2017 Forecast Budget anticipates a slight General Fund surplus of approximately $0.1 million for FY 2017, a shortfall of $0.6 million in FY 2018, and surpluses in the remaining years of the Forecast. During the forecast period, surpluses range between $0.1 million and $12.6 million with an approximate cumulative one-time surplus of $41.0 million. Assuming that the General Fund Budget Stabilization Reserve (BSR) is fully funded at the City Council approved target level of 18.5 percent of General Fund operating expenditures, $13.1 million would have to be set aside to maintain the target level. With these funds set aside, the one-time resources projected in this Forecast would decrease by $13.1 million from $41.0 million to $27.9 million. It is important to note that the majority of these surpluses are predicted in the last five years of the Forecast. The further we look into the future, the less reliable these predictions are. Fiscal Year 2017-2026 Long Range Financial Forecast The table includes a calculation for the net operating margin which reflects the year over year change of surpluses and shortfalls. With the net operating margin, it is assumed that each shortfall is addressed completely with ongoing solutions in the year it appears, and that each surplus is completely expended with ongoing expenditures. Based on these assumptions, the cumulative net operating margin, or ongoing surplus, during the forecast period is approximately $12.0 million, with the majority of these ongoing surpluses generated in the last five years of the Forecast. Although this Forecast presents overall a positive fiscal outlook for the City’s General Fund, it is important to note that it does not include the following potential impacts, which can increase or decrease the projected annual surpluses to the FY 2017 Projected Budget and the out-years of the Forecast: (1) ongoing labor negotiations; (2) funding of the Council approved Infrastructure Plan after completion of full design, increased construction costs, and prevailing wage requirements; (3) operating budget impact of Infrastructure Plan projects; (4) cost impact related to the Parks Master Plan; (5) additional costs related to the future Junior Museum and Zoo facility; (6) potential acquisition of the downtown Palo Alto Post Office; (7) one-time costs related to City assets managed by non-profits such as Avenidas Senior Center, the Palo Alto History Museum, the Ventura Child Care Center, the Junior Museum and Zoo, or the Scout Building; (8) Cubberley Community Center Master Plan; (9) construction loans for the Palo Alto Airport; (10) potential termination of the Fire Services Contract with Stanford University; (11) Cadillac Healthcare Federal Excise Tax expected to impact in calendar year 2018; (12) future changes to pension plan assumptions by CalPERS; (13) Transient Occupancy Tax increases City of Palo Alto Page 4 related to two new hotels on San Antonio Road; (14) Tax revenue alignment with updated Comprehensive Plan; and (15) changes in the local, regional, and national economy. At this time, staff projects a $6.5 million General Fund budget surplus for FY 2016. This surplus assumes City Council authorized budget amendments to date and includes higher tax revenue estimates as indicated in this Forecast ($5.5 million) and expenditure savings related to the Retiree Healthcare Implied Subsidy ($1.0 million) as discussed further in the Salary and Benefits section of this report. The majority of the excess revenue is related to the Transient Occupancy Tax of which $4.2 million will be recommended for transfer to the Capital Improvement Fund for the Infrastructure Plan as part of the Fiscal Year 2016 Midyear Budget Review report. This amount does not assume any other recommendations to adjust revenues and expenditure that staff intends to bring forward for City Council consideration as part of the FY 2016 Midyear Budget Review. During the next few months, staff will continue to monitor revenues and expenditures based on available information and include these updates in the FY 2017 Proposed Budget scheduled for release late April 2016. Officially, the Great Recession ended in June 2009. According to the National Bureau of Economic Research, the average duration of a business cycle from 1945 to 2009 lasted about six years and the period between the last two recessions was about ten years. Therefore, staff has provided an alternative Forecast model which assumes a recession in the first half of Fiscal Year 2019. As can be seen from this model, the City needs to start preparing for the next recession. As discussed this fall with the City Council and Finance Committee, during a recessionary period, the City is expected to receive less revenue and pension cost expenses increase. The Budget Stabilization Reserve has been used in the past in small parts to buffer revenue decreases. To address the anticipated higher pension costs, staff will bring forth a recommendation as part of the Fiscal Year 2017 budget to establish a 115 Supplemental Pension Trust Fund with one-time sources. The funds in the pension trust fund can be used in the future to mitigate rising pension costs for one or more fiscal years. Economic Outlook In preparing the FY 2017 to 2026 General Fund Long Range Financial Forecast, key economic indicators and measures available through various publications and reports were reviewed. Overall, the economic outlook for 2017 calls for continued measured optimism even as global economic conditions continue to produce uneven economic growth across regions and sectors. International As a world renowned hub of technological innovation, and at the heart of the Silicon Valley, Palo Alto is connected to the global economy in immeasurable ways. According to the October 2015 World Economic Outlook (WEO), “global growth for 2015 is projected at 3.1 percent, 0.3 percentage point lower than in 2014, and 0.2 percentage point below the forecasts in the July 2015 World Economic Outlook Update.”i City of Palo Alto Page 5 Slower global activity is taming inflation in 2015. The continued moderate growth is a combination of advanced economies anticipating continued grow contrasted with anticipated declines in emerging markets for the fifth year. With declining commodity prices, depreciating emerging market currencies, and increasing financial market volatility, downside risks to the outlook have risen, particularly for emerging markets and developing economies. Modest increases are anticipated in advanced economies as a result of the strengthening of the euro and a return of positive growth in Japan assisted by declining oil process and monetary policies.ii Looking forward, “Global activity is projected to gather some pace in 2016. In advanced economies, the modest recovery that started in 2014 is projected to strengthen further. In emerging market and developing economies, the outlook is projected to improve: in particular, growth in countries in economic distress in 2015 (including Brazil, Russia, and some countries in Latin America and in the Middle East), while remaining weak or negative, is projected to be higher next year, more than offsetting the expected gradual slowdown in China.”iii United States In November 2015, the Bureau of Economic Analysis revised their Q3 2015 Gross Domestic Product (GDP) second estimate to 2.1% compared to the 3.9% increase during Q2. The increase in Q3 is primarily reflective of “positive contribution from personal consumption expenditures, nonresidential fixed investment, state and local government spending, residential fixed investment, and exports that were partially offset by a negative contribution from private inventory investment.”iv Overall, Q1 2014 continues to be the worst first quarter showing since Q1 2009, amidst the Great Recession period, which has been attributed the sharp decline in output and productivity to unusually cold weather in much of the US in early 2014. According to the UCLA Anderson Forecast, the federal funds rate is forecasted to be about 1.5 percent by the end of 2016 and approximately 3.25 percent at the end of 2017. This combined with the continued job growth and anticipated wage growth will drive consumption levels upward in 2016 leading to the first year of greater than 3.0% in real GDP since 2005.v The chart below provides a quarterly view of GDP growth from 2009 to present. City of Palo Alto Page 6 As noted briefly above, the UCLA Anderson Forecast cites several factors attributing to their favorable outlook for 2016. As of December, UCLA Anderson Senior Economist David Shulman cites, that “employment remains healthy, with the economy generating jobs at a 200,000-a-month clip that will bring it further declines in the unemployment rate to 4.6 percent.”vi As a result of the continuing decline in unemployment, reaching nearly full employment levels, and the continued upward pressure on wage increases, it is anticipated that the likelihood of inflation reaching its 2.0 percent target will be achieved. National Unemployment levels continue to decline, and are holding steady at October 2015 levels of 5.0 percent in November 2015. This is 13.8 percent below November 2014 levels of 5.8 percent.vii With the higher wages and a slight rebound in oil prices and housing costs resulting in inflation reaching 2.0 percent, UCLA Anderson Forecast anticipated that the Fed will begin to normalize the Federal Funds rate and gradually begin to tighten.viii California California’s economy continues to be a bright spot in the nation’s economic outlook with job growth continuing to outpace national levels. According to the Bureau of Labor Statistics (BLS), California’s unemployment rate dropped from 7.2 percent in October 2014 to a preliminary estimate of 5.8 percent in October 2015, a 19.4 percent decline.ix The current UCLA Forecast echoes this and forecasts continued steady gains in employment through 2017 with an unemployment rate of 4.9 percent by the end of the forecast period. In addition, UCLA Anderson Forecast senior economist Jerry Nickelsburg reviewed economic indicators that differentiate the state of California from the U.S. average forecast such as trade through California’s ports, travel through international airports, state government finances, and residential construction and employment. Overall, continued steady growth through 2017 is anticipated in these sectors with some notable historical highs in port activity in September City of Palo Alto Page 7 2015 as well as record levels of travel, continued residential construction, and steady growth in employment of 2.6 percent for 2016 and 1.4 percent for 2017. California’s payroll will grow more, at about the same rate and personal income growth is estimated to be 4.3 percent in 2015 and forecast to be 3.4 percent in 2016 and 3.2 percent in 2017.x According to the Zillow Home Value Index, the median home value in California for October 2015 is $449,500. California home values have gone up 5.8 percent over the past year (October 2014 to October 2015) and Zillow predicts they will rise 2.8 percent within the next year. The median price of homes sold is $418.250. xi Palo Alto and the Bay Area Palo Alto’s traditional economic indicators of growth and prosperity, which are highlighted below, continue to be strong. The unemployment rate in the San Jose, Sunnyvale, Santa Clara Metropolitan Statistical Area (MSA), ticked up slightly in the preliminary October 2015 estimate to 4.0 percent, up from 3.7 percent in September 2015, but down from the October 2014 rate of 5.0 percent.xii The employment picture, though returning to normalcy nationally, is showing different influential factors. Of particular focus in the UCLA Anderson Forecast and significant to the Silicon Valley in particular is the office-using employment which includes the three leadings sectors – information, financial services, and professional and businesses services. These positions are significant as they have the highest average annual salaries for their employees ranging from $70,070 to $105,000 annually. This is compared to other employment sectors such as manufacturing, education and health, trades, and leisure and hospitality which range from $34,490 to $61,000 annually. Therefore, growth in these lucrative sectors is critical to the prosperity of cities as they bring significant purchasing power. Finally, home values in Palo Alto continue to reach new highs. According to the Zillow Palo Alto Real Estate Market Summary, the average price per square foot for Palo Alto was $1,468, an increase of 12.6 percent compared to the same period last year. The median sales price for homes for August 2015 to November 2015 was $2.5 million, a 22.5 percent increase from the same period a year ago. Over the last five years, sales have appreciated a staggering 154.2 percent in Palo Alto. The number of sales has increased 1.2 percent and the average list price for homes was $3.1 million, according to Trulia.xiii Fiscal Year 2017-2026 General Fund Long Range Financial Forecast The FY 2017-2026 General Fund LRFF projects a slight General Fund surplus of $0.1 million for FY 2017, a shortfall of $0.6 million in FY 2018, and surpluses in the remaining years of the Forecast. During the forecast period, surpluses range between $0.1 million and $12.6 million with an approximate cumulative one-time surplus of $41.0 million. Assuming that the General Fund Budget Stabilization Reserve (BSR) is fully funded at the City Council approved target level of 18.5 percent of General Fund operating expenditures, $13.1 million would have to be set aside to maintain the target level. With these funds set aside, the one-time resources projected City of Palo Alto Page 8 in this Forecast would decrease by $13.1 million from $41.0 million to $27.9 million. It is important to note that the majority of these surpluses are predicted in the last five years of the Forecast. The further we look into the future, the less reliable these predictions are. The operating margin reflects the variance between the projected General Fund revenues and expenditures for each year of the forecast or the annual surplus or deficit. With the operating margin, the year over year change in surpluses and deficits, it is assumed that each shortfall is addressed completely with ongoing solutions in the year it appears and that each surplus is completely expended with ongoing expenditures. During the Forecast period, the net operating margin fluctuates between negative $0.6 million and positive $2.9 million. Although this Forecast projects healthy revenue growth, the revenue growth is barely keeping pace with the projected expenditure growth during the first five years of the Forecast. In the second half of the Forecast, revenues substantially outpace expenditures resulting in significant surpluses ranging from $2 to $12 million annually. This is primarily due to tapering off of City pension rate increases as discussed further in the salary and benefits section of this report. Fiscal Year 2017-2026 Base Long Range Financial Forecast The graph below provides a representation of the operating and net operating margin of the base model as described above. City of Palo Alto Page 9 It should be noted that this Forecast, as outlined in the following sections of this report, does not include the following potential impacts to the FY 2017 Projected Budget and the out-years of the Forecast: (1) Labor negotiations: The City is currently in negotiations with the Palo Alto Police Officers Association (PAPOA), the International Fire Fighters Association (IAFF), the Service Employees International Union, the Police Management Association, and the Fire Chiefs Association. Any agreements reached between the City’s bargaining units and approved for the Management and Professional Personnel Compensation Plan and the City will be incorporated into future budgets and forecasts, as applicable. (2) Infrastructure Plan capital budget impacts: In June 2014, the Infrastructure Plan was approved by the City Council and contains $125.8 million in projects recommended by the Infrastructure Committee; however, the Plan’s construction and design costs were based on data from 2012. As construction costs have increased and the City is required to pay prevailing wages, the Plan is not sufficiently funded. However, the higher than anticipated revenues for Transient Occupancy Taxes related to new hotels and the 2% voter approved tax increase will partially offset the higher construction costs. (3) Infrastructure Plan operating budget impacts: In June 2014, the City Council approved the Infrastructure Plan which includes $125.8 million in projects recommended by the Infrastructure Committee. This Forecast does not assume ongoing operating impacts as a result of the Infrastructure Plan, but future forecasts will include operating cost impacts as the specific projects are designed. City of Palo Alto Page 10 (4) Parks Master Plan: the Parks Master Plan will be finalized in 2016 and future forecasts will include associated cost impacts as necessary. (5) Junior Museum and Zoo: In November 2014, the City Council directed staff to negotiate a capital lease with the Friends of the Junior Museum and Zoo for the reconstruction of the Junior Museum and Zoo. This Forecast does not assume any additional operating costs related to the renovated building. (6) Acquisition of the downtown Palo Alto Post Office: The City may acquire the downtown Palo Alto Post Office with the plan to relocate staff from leased facilities. The acquisition would be financed through issuance of debt with the annual debt service paid through lease cost savings. If the Palo Alto Post Office is acquired, it would require substantial improvements while the City pays the annual debt service, and during that time the City will also have to continue paying for leasing existing facilities. Staff is reviewing potential strategies, which would reduce the impact to the General Fund in the short-term. (7) City owned assets operated by non-profit organizations: This Forecast does not include any additional capital investments for the Avenidas Senior Center, the Palo Alto History Museum, the Ventura Child Care Center, the Junior Museum and Zoo, or the Scout Building. (8) Cubberley Community Center Master Plan: The FY 2016 Adopted Capital Budget included funding for the Cubberley Community Center Master Plan. Costs in excess of the dedicated Cubberley infrastructure funding as agreed to between the Palo Alto Unified School District and the City are not assumed in this Forecast. (9) Loans to the Airport Fund for capital improvement projects: Staff intends to apply for Federal Aviation Administration (FAA) reimbursable grants during the Forecast period. If approved, the FAA reimburses 90% of capital improvement costs. Since some of these capital improvements may bridge fiscal years, the General Fund may have to provide loans crossing fiscal years until the Airport Fund receives the FAA reimbursements. (10) Fire Services Contract with Stanford University: On October 8, 2013, the City received a Notice of Termination letter from Stanford with the intent to terminate the contract with the City no sooner than one year and no later than two years from the date of the notice. During the termination period as well as the last two months, the City continued to negotiate with Stanford to settle on a service level and cost. This Forecast assumes the continuation of the contract for $6.5 million. City of Palo Alto Page 11 (11) Cadillac Healthcare Federal Excise Tax: Beginning 2018, a 40 percent excise tax will be imposed on the value of health insurance benefits that exceed a certain threshold. CalPERS may be able to design healthcare premiums to stay below the threshold and discussions are in the preliminary stage. Congress is also discussing possibly delaying or modifying this tax. If the tax is applicable, the City may have to pay the tax. (12) CalPERS City contribution increases: Currently, CalPERS assumes an annual investment return of 7.5%. This Forecast assumes that CalPERS will meet the annual investment return. However, staff provided an alternative Forecast which assumes a poor investment return for the next ten years. Further, the CalPERS Board approved a gradual de-risking strategy, which is intended to reduce the assumed investment return to 6.5% over the next 20 years in the years when CalPERS earns an investment on its portfolio in excess of 11.5%. In the event that the de-risking strategy does not result in a reduction of the expected rate of return, the CalPERS board will revisit this assumption as part of their process starting in November 2017 with formal action to take place in February 2018. (13) Transient Occupancy Tax increases related to two hotels on San Antonio Road: The City is in the process of reviewing plans for two Mariott hotels with a potential location at San Antonio Road. This Forecast does not assume any potential Transient Occupancy Tax increases from these two hotels. (14) Tax revenue alignment with updated Comprehensive Plan: The City is currently in the process of updating its Comprehensive Plan including the potential fiscal impact of various land use scenarios. The fiscal impact of various land use scenarios will be brought forward for City Council discussion in 2016. (15) Changes in the local, regional, and national economy: This Forecast assumes a steadily growing local economy. Any changes may have positive or negative impacts on economically sensitive revenues such as Sales Tax and the Transient Occupancy Tax. At this time, staff projects a $6.5 million General Fund budget surplus for FY 2016. This surplus assumes City Council authorized budget amendments to date and includes higher tax revenue estimates as indicated in this Forecast ($5.5 million) and expenditure savings related to the Retiree Healthcare Implied Subsidy ($1.0) as discussed further in the Salary and Benefits section of this report. The majority of the excess revenue is related to the Transient Occupancy Tax of which $4.2 million will be recommended for transfer to the Capital Improvement Fund for the Infrastructure Plan as part of the Fiscal Year 2016 Midyear Budget Review report. This amount does not assume any other recommendations to adjust revenues and expenditure that staff intends to bring forward for City Council consideration as part of the FY 2016 Midyear Budget Review. City of Palo Alto Page 12 Since the Great Recession, the City Council has approved various strategies to reduce the costs of salaries and benefits. These strategies include: (1) employees paying their own CalPERS contribution (between 6 percent to 9 percent of salary) except for the members of the Fire Chiefs’ Association; (2) sharing the cost of health plan costs at 90/10; (3) creating a second pension tier (and the state implemented a third tier effective January 1, 2013); (4) reducing professional development expenses; (5) cost of living freezes for four years; and (6) terminating the Variable Management Compensation Plan. Continuing with previous actions to curtail the growth of benefits costs, in 2014, as part of approving the agreement with SEIU and the compensation plan for Management and Professional employees, the City Council approved the cost sharing of future health plan costs. However, in comparison to market studies to comparable agencies, the salaries of our employees, primarily safety employees, have fallen behind. Currently, the City is in negotiation with all of its bargaining groups. It is the City’s desire to retain and attract a talented workforce. Therefore, this Forecast includes salary and benefits increases to adjust employees’ salaries to the average of the market over the next few years. Due to these adjustments, for Fiscal Year 2018 only, revenue growth is outpaced by a salary and benefits growth resulting in a shortfall of about $0.6 million. Looking forward to the next fiscal year, in Fiscal Year 2019, this Forecast predicts a surplus of $0.9 million. Therefore, the projected Fiscal Year 2018 shortfall can be bridged with one-time funding. The next section of the report discusses the analysis and assumptions of major revenue and expenditure categories. Consistent with the 2016-2025 LRFF, the methodology for calculating changes for out-years of the Forecast (FY 2018 to FY 2026) are based on a historical analysis of increases using the Compounded Annual Growth Rate (CAGR) with adjustments factored in for known items. Staff performed a reasonableness test of the results. Typically, the average business cycle lasts six years and the period between the last two recessions was about ten years. Therefore, this report includes an alternative Forecast model with a recession assumed in Fiscal Year 2019. Revenues City of Palo Alto tax revenues continue to parallel the strong local economy. Robust residential and commercial property values, business driven transient occupancy and daily rates, and the emergence of new hotels have propelled key revenue sources upward since Fiscal Year 2013. The fundamental economic drivers of low unemployment, strong incomes in Silicon Valley, vibrant business activity, and the demand for Palo Alto property will continue to buttress revenue in the near future. City of Palo Alto Page 13 Fiscal Year 2017-2026 Long Range Revenue Forecast The tables above (also available in Attachment A) highlight the annual revenue estimates and year over year increases for this Forecast. Compared to FY 2016 projected, FY 2017 revenues are estimated to increase by $5.0 million, or approximately 2.6 percent. Based on the economic analysis presented in the previous section of this report, revenue estimates, which are primarily linked to the performance of the regional and local economy, are reflective of increased consumer spending, continued rise in home prices, and the opening of hotels. The upward trend of the City’s tax revenues is expected to continue over the next 10 years. These tax revenues have significantly improved since the beginning of the Great Recession. The table above illustrates the steady growth projected for the General Fund’s revenue streams, by percentage, from FY 2017 through FY 2026. During the 2013 Finance Committee discussions, it was recommended that staff consider use of a historical annual growth rate derived for each tax revenue source to project future revenue streams. This methodology was used in the final forecast presented for FY 2015 to 2025 and City of Palo Alto Page 14 has been used in this forecast as well. The Compound Annual Growth Rates (CAGR) utilized in this Forecast is cited in each revenue section and reflected in the revenue section table. The graph above depicts a historical and the base model projected view of the five major General Fund tax revenues. It includes 10 years of actual revenue history; the projections for FY 2016 based on actual data available for the first five months of the fiscal year; as well as the projections for FY 2017 and the subsequent years of the Forecast. Revenue forecasts are based on current data and application of the Compound Annual Growth Rate (CAGR) methodology. The following section is a detailed discussion of General Fund Tax revenue and other major revenue sources by category. Sales Tax Sales taxes have risen from a low of $17.9 million in FY 2010 to a projected level of $27.9 million in FY 2016. They are expected to grow by a compound annual growth rate of around 2.6 percent through FY 2026. Staff has factored into the forecast weakening receipts over the past several years from a few key generators. In addition, the ongoing movement of tangible good purchases from brick and mortar stores to online vendors continues and poses a long-term threat. Evidence of this was reported in a December 1, CNBC article, “According to the Adobe's Digital Index, total online sales on Cyber Monday rose 16 percent compared to last year, to $3.07 billion.” The article goes on to say that in-store data “showed sales were down an estimated 10.4 percent over Black Friday weekend” compared to the prior year. As reported to Council, there was a one-time tax windfall from one vendor in FY 2014 and a Government Accounting Standards Board tax accrual adjustment in FY 2015. In each year, sales tax was reported at $29 million. As shown below, the FY 2016 and FY 2017 projections return to a more realistic level in 2017. City of Palo Alto Page 15 TABLE 1: SALES TAX REVENUE BY FISCAL YEAR (MILLIONS) Fiscal Year 2012 2013 2014 2015 2016 2017 Revenue $22.1 $25.6 $29.4 $29.7 $27.9 $28.5 Restaurant and auto sales are trending higher, while department store and electronic firm sales are trending lower. The State will terminate its “triple flip” program this January so the City will receive more timely payments and slightly higher interest earnings due to better cash flow. The CAGR applied to the period FY 2016 through FY 2025 is 2.6 percent which is in line with historical growth rates. Property Tax As the table below indicates, since FY 2012 property taxes have risen substantially. Staff projects this source to grow at 5.9 percent over the next ten years which is in line with historical trends. The recent purchases of the Tibco Site in the Stanford Research Park ($330 million) and the Epiphany Hotel ($71.6 million) evidence a compelling commercial real estate market. Other contributing factors include: single family home sales that have exceeded asking prices and the unleashing of latent property values from the sale of long held homes that were “shielded” from assessed value appreciation by Proposition 13. TABLE 2: PROPERTY TAX REVENUE BY FISCAL YEAR (MILLIONS) Fiscal Year 2012 2013 2014 2015 2016 2017 Revenue $26.5 $28.7 $30.6 $34.1 $35.1 $37.5 The City’s property tax estimate for FY 2016 is based on information received from quarterly meetings with the Santa Clara County Assessor’s Office. The estimate includes appeals on record with the Assessor’s Office, additions to the roll, and movements in assessed values. Projections beyond FY 2016 are based on historical growth rates. The CAGR used in this 10 year forecast equals 5.9 percent, slightly higher than the 5.4 percent in last year’s forecast. This higher growth rate is justified by the factors cited above. As requested by the City Council, staff contacts the Palo Alto Unified School District (PAUSD) regarding their assumptions in property tax growth. Typically, the initial growth assumptions used by PAUSD in developing their budget are lower than the City’s. As the budget year progresses, however, PAUSD will align their property tax revenue with actual increases that tend to be closer to the City’s projections. PAUSD’s growth rate assumption for FY 2016 was 5.34 percent. In FY 2015, the Administrative Services Department contracted with a firm to produce detailed reports on property taxes. The consultant’s reports have provided key insights into Palo Alto’s real estate market that supports property taxes growing at around 6 percent per year, including: City of Palo Alto Page 16  There are 8,010 residential properties in Palo Alto under $600,000 in Assessed Value (AV). These properties, over a seven year period ending in FY 2015, turned over at an average rate of 582 annually.  On average, 3.1 percent of the above residential parcels annually changed ownership and the average AV increased by 171 percent. For example, a property with an AV of $1,000,000 is expected to sell in today’s market at $1,710,000 which is somewhat conservative given current sale prices.  Per the 2015-2016 Assessor’s Roll, average Assessed Value of residential properties in Palo Alto equal $1,080,000. Transient Occupancy Tax (TOT) As the table below shows, Transient Occupancy Taxes continue to perform exceptionally well. As summarized in the table below, average daily room rates and occupancy levels continue to demonstrate considerable strength since FY 2011. Generally, occupancy levels between 80 and 85 percent indicate full occupancy. Demand for Palo Alto rooms is strong, leading to construction and planned construction of five new hotels. A vibrant business and tourist environment has led to a surge in hotel bookings from San Francisco down through the Peninsula to San Jose. TABLE 3: TRANSIENT OCCUPANCY TAX BY FISCAL YEAR (MILLIONS) Fiscal Year 2012 2013 2014 2015 2016* 2017 General Purpose Revenue (millions) $9.7 $10.8 $12.3 $13.4 $15.3 $16.1 Infrastructure Revenue (millions) N/A N/A N/A $3.3* $9.2 $9.7 TOTAL $9.7 $10.8 $12.3 $16.7 $24.5 $25.8 Average Daily Room Rate $165 $182 $208 $208 $253 N/A Average Occupancy (percent) 79% 80% 79% 79% 80% N/A * This $3.3 million is currently retained in the Budget Stabilization Reserve to support Infrastructure Plan projects, as recommended for approval by the Finance Committee as part of closing the Fiscal Year 2015 budget. ** Projected revenue based on trend and Fiscal Year 2016 year to date data. Average Daily Room Rate and Occupancy are year-to-date through October 2015. This forecast includes estimated revenues for all of the new hotels that have come on-line, the Epiphany and the two new Hilton hotels as well as the Westin Annex which is expected to open this year. Plans for a hotel on the Ming’s restaurant site have been terminated. The new hotels planned for San Antonio Road are not included in the LRFF. Revenues from the 2.0 percent TOT increase effective January 1, 2015 and from the new hotels that are dedicated to infrastructure are isolated in the LRFF. The CAGR applied to the period FY 2016 through FY 2026 is 4.8 percent which is in line with historical growth rates. City of Palo Alto Page 17 Documentary Transfer Tax (DTT) After two solid years of unusually strong performance, the Documentary Transfer Tax will likely approach more normal levels in FY 2016. Through November 2015, transactions and receipts are down 24 percent and 35 percent, respectively, compared to the same prior year period. As mentioned above, there were sizable, one-time transactions (Hudson Pacific purchases of office space) along the Page Mill corridor last FY that are unlikely to be duplicated in FY 2016. Based on current activity, staff expects $7.1 million in FY 2016 with a mild uptick in FY 2017 to $7.4 million. TABLE 4: DOCUMENTARY TRANSFER TAX BY FISCAL YEAR (MILLIONS) Fiscal Year 2012 2013 2014 2015 2016 2017 Revenue $4.8 $6.8 $8.1 $10.1 $7.1 $7.4 The CAGR applied to the period FY 2016 through FY 2026 is 5.8 percent, again, in line with prior year CAGR trends. Utility Users Tax (UUT) The Utility Users Tax forecast includes a 5 percent tax on water, gas and electric usage and a 4.75 percent tax on telephone activity. In FY 2015, the step down tax for large users of utilities was eliminated. Receipts anticipated from the UUT are based on the Utilities Department’s five-year revenue and rate projections. These estimates could change as the department discusses its proposed rate plan with the Utilities Advisory Commission and the City Council during the annual budget process. With the drought and heightened water conservation efforts as well as lower gas prices and consumption, the utilities UUT is expected to decline from FY 2015 to FY 2016. Revenues in FY 2015 registered at $7.6 million and these are expected to drop to $7.1 million in FY 2016. Upward movement in revenues is anticipated in FY 2017 with increasing rates. Telephone receipts have been increasing marginally since FY 2014 and are expected to do so despite the drop of 0.25 percent in the UUT rate for this category. Other Taxes & Fines Based upon a review of historical collection patterns, it is anticipated that the budgeted revenue estimate for this category will need to be reduced as part of the FY 2017 Proposed Operating Budget. As such, this forecast assumes a reduction of 7.2 percent, primarily attributable to lower parking violations and library fines. In the remaining years of the forecast, revenues are anticipated to increase between 2.7 and 4.9 percent. Charges for Services For FY 2017, total revenues in this category will increase 1.7 percent or $296,000 from the FY 2016 Adopted Budget. Revenues collected primarily reflect the costs to provide services to the community and therefore, are significantly impacted by personal service costs. The slight increase reflects an increase in estimated receipts to maintain cost recovery levels in FY 2017 City of Palo Alto Page 18 partially offset by any one-time revenue adjustments approved as part of the FY 2016 Adopted Budget and adjustments reflective of the Golf Course closure in Fiscal Year 2017. The golf course revenues are decreased by $542,000 from the FY 2016 Adopted budget due to the anticipated closure. This decline in revenues is partially offset by a reduction in contract services associated with operating the Golf Course. As discussed in City Manager Report (CMR) #6335, to be heard by the City Council on December 14th, 2015, the Golf Course is now anticipated to remain open through the end of FY 2016 and construction is now anticipated to begin in the summer of 2016 and continue through FY 2018. Ongoing, this Forecast assumes an increase in charges for services revenue by approximately 3.1 percent to account for general salary and benefit increase included in the Forecast. These figures do not include Charges for Services revenue for Stanford Fire & Dispatch which is explained in further detail below. Stanford Fire & Dispatch Services The City has two separate agreements with Stanford University to provide fire response services and emergency dispatch services. As part of these agreements, Stanford is charged 30.3 percent of the Fire Department’s net cost and 16 percent of the Police Department’s Communication and Dispatch Division to reimburse the City for Stanford’s proportional share of these services. The term of the fire response service contract between the City and Stanford is through September 30, 2026; however, at Stanford’s request, the two parties have been in negotiations over the past two years to restructure the contract. On October 8, 2013, the City received a Notice of Termination letter from Stanford with the intention to terminate the contract with the City no sooner than one year and no later than two years from the date of the notice. During the termination period as well as the last two months, the City continued to negotiate with Stanford to settle on a service level and cost. Based on outcome of these negotiations, this Forecast assumes the continuation of the Fire Services contract for $6.5 million and dispatch contract for $741,000 with Stanford University escalated by the increased salary and benefits costs. Permits and Licenses Revenue from permits and licenses has experienced consistent growth over the past several years, primarily due to increased development activity around Palo Alto. Based on year-to-date estimates, FY 2016 revenues are projected to reach the Adopted Budget revenue estimate of $8.2 million. Revenues collected primarily reflect the costs to provide services to the community and therefore, are significantly impacted by personal service costs. In FY 2017, revenues in this category are expected to increase 5.6 percent, consistent with the projected increased personal service costs. From the FY 2016 projected level with ongoing annual increases of 2.6 percent through the forecast. As discussed in the FY 2016 Adopted Budget, the Planning and Community Environment and Development Services departments are reviewing the cost recovery model for these departments. Upon completion of this analysis, the staff will evaluate changes in planning and development fees and bring forward recommended adjustments as appropriate as part of the annual budget process. City of Palo Alto Page 19 Return on Investment Interest earnings continue to be depressed as a consequence of the Federal Reserve’s loose monetary and interest policies. Expectations for earnings from investments are around $0.9 million which is a 1.9 percent increase from FY 2015 yearend projections. Rental Income The largest source of rental income comes from the City’s Enterprise Funds and the Cubberley Community Center. Compared to the FY 2016 Adopted Budget, rental income will decrease from $15.3 million to 15.0 million. The decrease includes a projected loss of $500,000 in rental income at Cubberley due to Foothill College moving out. As part of the development of the Fiscal Year 2017 budget, staff will pursue replacement tenants to offset the rental loss figure related to Foothill College. The forecast does assume that by Fiscal Year 2018, Cubberley will have new tenants on board resulting in a rental income revenue increase of $200,000. The forecast out years also assume a 2.6 percent growth for all rental properties, except for the Refuse Fund rent which is assumed until FY 2021 as approved by the City Council to account for the closing costs related to the Middlefield Well landfill site. Revenue from Other Agencies Included in this category is funding from Community Services Outreach theatre programs, reimbursements from the Palo Alto Unified School District (PAUSD) for School Resource Officers, and state and federal grants, if received. Many of these revenue streams are difficult to predict and are dedicated often to specific purposes. In this category revenues over the past five fiscal years have remained well below $0.5 million. This forecast assumes $0.4 million for FY 2017 with a growth rate of approximately 1.3 percent in subsequent years due to the unpredictability of this funding source. Charges to Other Funds Approximately 86 percent of this category is General Fund administrative cost plan charges to the Enterprise and Internal Service Funds. Internal support departments such as ASD, HR, and Council Appointees provide services to enterprise and internal service funds. The costs for these services are recuperated through the administrative cost plan charges. The charges for Fiscal Year 2017 are determined based on actual services provided in Fiscal Year 2015. The FY 2017 projected amount is $11.5 million, a decrease of 3.2 percent, from the FY 2016 Adopted Budget. The decrease in cost plan charges to the Enterprise and Internal Service funds is attributable to internal support departments providing more support to General Fund departments in Fiscal Year 2015. The forecast includes increases ranging between 2.6 to 4.9 percent each year based primarily on assumed increases in salary and benefit costs. In addition to the General Fund administrative cost plan, this revenue category includes several other allocations, most notably Public Works administration charged to Public Works Enterprise Funds and public safety communication services provided to the Utility Department. City of Palo Alto Page 20 Other Revenues Major revenue sources in this category are reimbursements for the Shuttle program (e.g. City of East Palo Alto), Animal Services charges to Los Altos and Los Altos Hills, reimbursements from PAUSD for its share of Cubberley and athletic field maintenance, donations from non-profits to City libraries, and miscellaneous revenues. Revenues for this category are estimated to decline by 16.4 percent in FY 2017, mostly due to the elimination of $0.3 million in one-time revenue in approved in the FY 2016 Adopted Budget. The FY 2017 projected revenue for this category is $1.3 million, with a 2.6 percent to 2.8 percent annual increase forecasted for through FY 2026. Operating Transfers In Operating Transfers include the equity transfer from the Electric and Gas funds as well as transfers from the University Ave Parking Permit Fund. In accordance with a methodology approved by Council in June 2009, the equity transfer is calculated by applying a rate of return to the capital asset base of the Electric and Gas funds. This rate of return is based on PG&E's rate of return on equity as approved by the California Public Utilities Commission (CPUC). Using the Utility Department’s projections from the Electric and Gas Five Year Financial Forecasts, as approved by the City Council in spring 2015, the equity transfer from the Electric and Gas funds are projected to increase from $17.3 million in FY 2016 to $18.8 million in FY 2017 (8.4 percent), and then increase annually by 2.3 percent over the rest of the forecast period. The higher increase in FY 2017 reflects updated Gas Fund capital asset data while the subsequent years reflect the average annual adjustment in the equity transfer since 2009. Overall Operating Transfers are estimated to increase to $20.1 million in FY 2017, an increase of $1.5 million from the 2016 Adopted Budget level of $18.6 million. Expenditures As part of developing the FY 2017 Forecast expenditure budget, the General Fund expenditure categories have been adjusted by removing FY 2016 Adopted Budget one-time expenditures and updating major cost elements such as salary and benefits costs. The tables below display the General Fund expense forecast. Compared to FY 2016 Adopted Budget, FY 2017 expenditures are estimated to increase by $9.7 million, or 5.2 percent primarily due to increased salary and benefits, an increased transfer to infrastructure, and allocated charges costs from Enterprise Funds and Internal Service Funds. City of Palo Alto Page 21 Fiscal Year 2017-2026 Long Range Expenditure Forecast Salary and Benefits The table above (also available as an attachment) depicts the salaries and benefits costs for the next ten years. Over the Forecast period, the salaries and benefits cost gradually increase in comparison to the total expenditure budget. In FY 2017, salaries and benefits costs represent 60.6 percent of the expenditure budget; in FY 2026, the salaries and benefits cost represent 61.8 percent of the budget. In the same period, though, the benefits cost as a percentage of total salaries and benefits costs increase from 50.6 percent in FY 2017 to 53.7 percent in FY 2026. Over the Forecast period, salaries compounded growth is 28.0 percent versus a compounded growth in benefits costs of 42.4 percent. This compounded growth is less than estimated in the previous Forecast primarily due to lower estimated City pension contributions in the out-years of the Forecast as described in more detail below. The following sections describe the assumed increases in salary and benefits costs and depict the reasons for the faster increasing benefits versus salaries costs. Salary Consistent with the City’s change in salary budget methodology that was implemented as of recent budgets, positions are budgeted at actual rate of pay including benefits as of fall 2015. Then, by position, salary costs are updated in accordance with applicable Memoranda of Understanding (MOU) between the City and its labor groups and the Management and Professional Personnel and Council Appointees Compensation Plan. It is important to note that the City is currently in negotiations with the Palo Alto Police Officers Association (PAPOA), the City of Palo Alto Page 22 International Fire Fighters Association (IAFF), the Service Employees International Union, the Police Management Association, and the Fire Chiefs Association. This Forecast includes salary and benefits increases based on projected increases in the cost of living and market based adjustments. The Forecast also assumes step increases consistent with applicable MOUs and merit increases for Management and Professional employees. Benefits Pension The forecast includes the pension rates from CalPERS as of the June 30, 2013 valuation for the City’s Miscellaneous and Safety plans, as updated by Bartel Associates (Bartel), the City’s actuary. Staff asked Bartel to update the pension rates based on the latest available information from CalPERS since CalPERS advised cities that the actuarial valuations as of June 30, 2014 will become available in December and project the rate for the ten-year period of the Forecast. In the last Forecast, staff relied on the CalPERS projections and extended those for the out years of the Forecast. Once CalPERS releases the latest valuation, staff will update the pension costs for the Fiscal Year 2017 budget as necessary. As shown in the table below, the FY 2017 pension contribution rates for the Miscellaneous and Safety plans, as calculated by Bartel increased from the current year. For the Miscellaneous Plan, the projected pension contribution rate increase is 1.8 percentage points from the FY 2016 rate of 27.7 percent to a FY 2017 rate of 29.5 percent. For the Safety Plan, the projected pension contribution rate increase is 2.7 percentage points, from the FY 2016 rate of 41.9 percent to a FY 2017 rate of 44.6 percent. The table below shows the pension contribution rates from FY 2018 through FY 2026. TABLE 5: PENSION RATES BY PLAN (FISCAL YEAR) Pension Plans 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 Miscellaneous 27.7% 29.5% 31.3% 33.1% 34.9% 35.3% 35.6% 35.4% 35.2% 35.0% 31.9% Safety 41.9% 44.6% 47.9% 50.8% 53.6% 54.1% 54.6% 54.1% 53.7% 53.2% 52.8% The City pension contribution rates assumed in this Forecast are substantially lower for the last few years of the Forecast period than assumed in the last Forecast due to a change in methodology for projecting the rates. Last year, staff used a linear extrapolation of rate increases provided by CalPERS during the first four years (CalPERS only provides rates for five fiscal years). This year, staff asked Bartel and Associates to provide projection of the City Contribution rates as presented to the Finance Committee in November. To exemplify the impact of this change in methodology, the last Forecast assumed for FY 2025 a 42.6% City contribution rate for Miscellaneous employees and a 64.3 % City contribution rate for Safety employees. The lower City contribution rates for this Forecast resulted in lower overall benefits costs. It is important to note, however, that the CalPERS Board approved a de-risking policy of its investment portfolio in order to reduce the assumed investment return of 7.5% to 6.5% over a City of Palo Alto Page 23 20 year period. With this policy CalPERS will only reduce the investment return assumption in years with investment returns higher than 11.5%. However, the Board is scheduled to revisit this policy in February 2018. If the Board decides to reduce the assumed investment return regardless of the actual earnings at this time, the City’s contribution rate would most likely increase for FY 2021. Retiree Healthcare This Forecast includes the Annual Required Contribution (ARC) per the May 2014 actuarial valuation based on information as of June 30, 2013, (accepted by the City Council on June 9, 2014) for the City’s retiree healthcare plan as updated by Bartel. Bartel’s update to the last actuarial valuation assumes the latest CalPERS mortality rate assumptions, incorporates the investment gain for the Retiree Healthcare Trust Fund as of June 30, 2015, and assumes a lowering of the assumed investment return assumption from 7.61% to 7.25%. Currently, Bartel is preparing the Retiree Healthcare valuation as of June 30, 2015. Staff will incorporate the findings of the valuation as part of the FY 2017 budget. As this Forecast predicts surpluses in the out-years, staff intends to revisit the investment earning assumptions for further reductions in coming years. The table below details Bartel’s estimate for the City’s annual Retiree Healthcare contribution by the General Fund, non-general funds, and all funds for the next ten years. TABLE 6: RETIREE HEALTHCARE ANNUAL REQUIRED CONTRIBUTION (IN MILLIONS BY FISCAL YEAR) Fund 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 General Fund $10.0 $10.9 $11.2 $11.6 $12.0 $12.4 $12.8 $13.2 $13.6 $14.0 $14.5 Non-General Funds $4.8 $5.2 $5.4 $5.6 $5.8 $5.9 $6.1 $6.3 $6.6 $6.8 $7.0 TOTAL $14.8 $16.1 $16.6 $17.2 $17.8 $18.3 $18.9 $19.5 $20.2 $20.8 $21.5 On June 9, 2014, City Council accepted the Retiree Healthcare Plan GASB 45 Actuarial Valuation as of June 30, 2013 and approved full funding of the Annual Required Contribution (ARC) for Retiree Healthcare for FY 2015 and FY 2016. As documented in the report (CMR #4891) which recommended approval of full payment of the ARC, the primary reason for the increased ARC for Retiree Healthcare was the inclusion of a new actuarial standard regarding the implied subsidy of healthcare premiums of active employees in relationship to healthcare premiums for retirees. CalPERS blends active employees with pre-Medicare retirees and charges them the same medical premium; however, younger employees on average consume less healthcare services and therefore are subsidizing older employees and retirees. The implied subsidy is the difference between average retiree claims and retiree premiums charged by CalPERS. Consistent with City Council direction, as recommended by staff, the City budgeted for full payment of the ARC for FY 2015 and FY 2016, including the implied subsidy. The implied subsidy for FY 2015 was $1.9 million for all funds. As part of preparing for the FY 2015 CAFR, staff worked closely with the City’s actuary, the managers of the City’s trust fund for Retiree City of Palo Alto Page 24 Healthcare, and the City’s external auditor about the implied subsidy in the Retiree Healthcare Fund. After many discussions, staff realized that the implied subsidy budgeted in the Retiree Healthcare Fund should have been budgeted as a contribution from the City’s healthcare premiums for active employees. However, the FY 2015 budget had fully funded the City’s healthcare premiums of approximately $17.4 million for active employees. Therefore, the cost of healthcare premiums related to the implied subsidy in the amount of $1.9 million was budgeted twice. For FY 2015, the savings of healthcare premiums related to the implicit subsidy remained in the General Benefits Fund for future use. For FY 2016, staff will bring forward recommendations as part of the FY 2016 Midyear Budget Review report to correct departmental budgets regarding the implied subsidy. Starting with this Forecast and the FY 2017 Budget, staff correctly budgeted for the implied subsidy for active employees healthcare premiums. This means that for all funds approximately $2.2 million of the active employees healthcare premiums are included in the Retiree Healthcare ARC. Healthcare Consistent with the previous Forecast and as a result of the most recent labor agreement between the City and the Service Employees International Union (SEIU), the City’s contribution amount towards medical costs for SEIU employees is based on a flat contribution from the City with the employee contributing towards the remaining medical plan premium. This flat contribution towards medical costs is also used for the Management and Professional employees. All other labor groups eligible for medical benefits will remain on the 90/10 contribution structure until new labor agreements are reached with the City and the affected bargaining groups. This Forecast assumes an annual health care cost inflator of 8 percent for the labor groups on the 90/10 medical benefit structure, and a 4 percent annual health care cost inflator for the labor groups on the flat rate contribution structure. Consistent with the previous Forecast and with historical trends, the 2017-2026 LRFF assumes a 4 percent increase for dental and vision costs for the out-years. Contract Services The FY 2016 Adopted Budget included $17.4 million to fund contract services of which approximately $2.4 million was for one-time items that include $0.3 million for trash receptacles on University Avenue, $0.3 million for the Fry’s Master Plan, and $0.3 million for the continuation of services at the Palo Alto Animal Shelter and transition operations to a non- profit. This $2.4 million has been removed from the forecast for FY 2017 and beyond. In addition, the FY 2016 Adopted Budget assumed that the Golf Course would be closed during the second half of the fiscal year; however, due to continued delays in securing the required permits to begin the Golf Course Reconfiguration Project, as detailed in CMR #6335 to be heard by City Council on December 14, 2015, this Forecast assumes that the project will begin in early FY 2017. As a result, contractual expenses related to the Golf Course are anticipated to be reduced by approximately $0.6 million from the FY 2016 Adopted Budget level. This reduction in Golf Course expenses is partially offset by a reduction in revenue collections in Charges for Services. In FY 2018, upon the assumed completion of the Golf Course Project, contractual expenses will increase by approximately $0.9 million. City of Palo Alto Page 25 As discussed with the Finance Committee in October, staff continues to look for implementing alternative service delivery models such as partnering with a non-profit agency to provide animal services or identifying a partner for the City’s swim program. For the FY 2017 Forecast Budget year, $0.1 million has been added for the maintenance of the Magical Bridge playground and parkland maintenance. In the out-years of the Forecast, a 2.6 percent growth factor for contract services is assumed. This is aligned to the 20 year historical average of the San Francisco Metropolitan Statistical Area Consumer Price Index – All Urban Consumers of 2.6 percent. Supplies & Materials The category for Supplies and Materials decreases from $3.7 million in FY 2016 to $3.6 million in FY 2017 due to the elimination of one-time items funded in the FY 2016 Adopted Budget. For the out-years of the Forecast, it is assumed that costs will increase based on the 2.6 percent annual CPI increase. General Expense This category includes costs for travel and meetings, telephone and non-city utilities, contingency accounts, subsidies and grants provided through the Human Services Resource Allocation Process (HSRAP), and bank card service charges. The FY 2017 Forecast for this category remains flat as compared to FY 2016 at $4.7 million. For the remaining years of the forecast, this category assumes annual increases between 2.5 and 2.6 percent. These figures do not include General Expenses for the Cubberley Lease which is explained in further detail below. Cubberley Lease In Fiscal Year 2015, the City and Palo Alto Unified School District (PAUSD) agreed to an extension of the Cubberley Lease by five years starting January 1, 2015. As part of the lease agreement, the City Council approved creation of a fund for Cubberley infrastructure improvements. Based on the new lease, $1.9 million will be transferred to the Cubberley Property Infrastructure Fund for future infrastructure improvements. Therefore, the $1.9 million is classified as an Operating Transfer Out which is discussed in further detail below. With the Cubberley infrastructure funds set aside, the FY 2017 Forecast Budget includes $5.8 million for Cubberley Lease payments. In accordance with the lease agreement, the Forecast assumes a 3.0 percent annual CPI increase for the lease payments to the Palo Alto Unified School District (PAUSD) for the Cubberley facility. Also, the lease agreement period is five years; however, for planning purposes in this Forecast, it is assumed that the agreement will continue during the entire Forecast period. Rents & Leases Rent and Lease expenses for FY 2017 are estimated to increase by $38,000 from the FY 2016 adopted level of $1.5 million. The largest expense in this category is $1.1 million for the City of Palo Alto Page 26 Development Services Center. From FY 2018 forwards, this expense is expected to increase by 2.6 percent per year. Facilities & Equipment Facilities and Equipment expenses for FY 2017 are projected to decrease by 20.1 percent, or $0.1 million, as compared to the FY 2016 Adopted Budget, due to the elimination of one-time funding included in FY 2016. One-time items funded during FY 2016 include the purchase of 30 AEDs ($50,000), community center furniture replacement ($25,000), and the build out of office space at the Development Center ($20,000). After the elimination of one-time funding, projected expenses in this category of $0.5 million will remain fairly consistent in FY 2018 and beyond. Consistent with the 20-year CPI for the San Francisco San Jose Metropolitan Statistical Area, the forecast assumes a 2.6 percent annual increase starting in FY 2018. Allocated Charges Allocated Charges represent expense allocations by the City’s enterprise and internal services funds for services and products they provide to General Fund departments. In FY 2017, these charges are estimated at $18.1 million including utilities usage (24.2 percent or $4.4 million), liability insurance (7.5 percent or $1.4 million), technology costs (33.9 percent, or $6.1 million), vehicle equipment and replacement costs (27.7 percent or $5.0 million), and other costs (6.7 percent, or $1.2 million). The FY 2017 charges of the forecast updates the revenue and expense for these cost plans based on the most current information available at the time of Forecast development. Growth of 2.6 percent is anticipated in the out-years, which is based on the average annual expense growth over the forecast period. Operating Transfers Out Operating Transfers Out includes transfers from the General Fund to the Debt Service Fund, Technology Fund, and Airport Fund. Fiscal Year 2016 year-end projected transfers out total $1.8 million, and are expected to remain at that level for FY 2017. In FY 2018, the transfer level is anticipated to increase by approximately $0.3 million, primarily attributable to debt service payments for the Golf Course Reconfiguration project ($0.5 million), partially offset by the elimination of a transfer to the Airport Fund ($0.3 million) Transfer to Infrastructure In FY 2016, the adopted General Fund transfer to the Capital Improvement Fund is $19.0 million, which includes the base transfer of $14.0 million and $5.0 million from additional Transient Occupancy Tax (TOT) proceeds generated through a two percentage point TOT increase as well as through the addition of new hotels. Incremental TOT increases from the rate increase and new hotels are dedicated to the Capital Improvement Fund to support the Infrastructure Plan, consistent with City Council direction. The transfers to the Capital Improvement Fund are anticipated to increase significantly as compared to the FY 2016 Adopted Budget, as the revenue generated from these new sources has outpaced initial City of Palo Alto Page 27 projections. In FY 2016, an additional $4.2 million is anticipated to be transferred to the Capital Improvement Fund. In the out-years of the forecast, the TOT-associated transfer is anticipated to increase between 4.1 and 5.2 percent annually. These additional increases will help in offsetting the rising costs of Infrastructure Plan projects and ensuring the projects in the plan will remain fully funded. Additionally, the base transfer to the Capital Improvement Fund is anticipated to increase by 2.6 percent each year. Finally, this category includes the $1.9 million transfer to the Cubberley Property Infrastructure Fund, described earlier in this document. This transfer remains flat in all out-years of this Forecast. Alternative Fiscal Year 2017-2026 Long Range Financial Forecast In order to provide potential alternative perspectives, staff analyzed two other long range alternatives including one with a low pension investment return and another with a projected recession beginning in FY 2019. CalPERS Poor Investment Return As discussed with the City Council in September 2015 and the Finance Committee in November 2015, Bartel Associates provided the City with a continuous poor CalPERS investment performance scenario. A continuous poor CalPERS investment scenario which Bartel defines as investment returns between 0.2% and 4.1% will result in exceedingly high pension rates. The table below shows the Bartel projected City pension contribution rates by plan based on continuous poor investment results. TABLE 7: PENSION RATES BY PLAN (FISCAL YEAR) WITH FOR POOR INVESTMENT RETURNS Pension Plans 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 Miscellaneous 27.7% 29.5% 31.3% 33.8% 36.9% 39.1% 41.6% 43.8% 45.6% 47.0% 45.4% Safety 41.9% 44.6% 47.9% 52.0% 57.0% 60.3% 64.1% 67.6% 70.2% 72.2% 73.9% Based on these higher annual pension rates, pension costs would increase by a total of $34.0 million over the Forecast period, compared to the base model. The General Fund annual surplus in FY 2018, the first year impacted by the higher rates, would be reduced from $1.1 million in the base model to $0.7 million, a 36 percent reduction. This trend would continue through FY 2026 as the projected General Fund surplus of $3.4 million in FY 2026 would become a General Fund deficit of $5.4 million. During the Forecast period, the net operating margin fluctuates between positive $0.6 million and negative $5.4 million. This model does not project any additional revenue growth compared to the base model, which is the main reason expenditures begin to outpace revenue in FY 2021 and this gap continues to grow through FY 2026. City of Palo Alto Page 28 Fiscal Year 2017-2026 Long Range Revenue Forecast – CalPERS Poor Investment Return Alternate Model Fiscal Year 2019 Recession Alternate Forecast As described previously, the assumptions included in this Forecast, consistent with previous forecasts, are based on a historical analysis of increases using the Compounded Annual Growth Rate (CAGR) with adjustments factored in for reasonableness. The adjusted CAGR model factors in the impact of prior recessions but does not make assumptions about when a recession may occur. Typically, the average business cycle lasts six years and the period between the last two recessions was about ten years. Below, an alternative Forecast model is presented for informational purposes showing the projected impact of a recession beginning in FY 2019. This recessionary model adjusts the projected tax revenues and decreases the rate of growth for certain non-salary expenditures, which would be expected when the next downturn occurs. Assuming an onset of a recession at the beginning of FY 2019, as can be seen in the table below, a significant annual deficit of $9.7 million would exist in FY 2019. Assuming the FY 2019 deficit is not solved with ongoing expenditure reductions the annual deficit would grow to between $10.6 and $21.7 between FYs 2020 and 2024. However, as shortfalls are addressed primarily due to expenditure reductions, the subsequent ongoing deficits are reduced as shown in the net operating margin analysis. By addressing the net operating margin shortfalls over three years, the City will return to surpluses starting with FY 2022. The recessionary model assumes a reduction in major tax revenues, though they are anticipated to decline at a lower rate than those in the Dot.Com bubble and Great Recession. The economically sensitive revenue sources follow somewhat different patterns in reacting to a recession. Acting like a harbinger, historical data indicates that Documentary Transfer Taxes decline just prior to the onset of a downturn. City of Palo Alto Page 29 Sales Tax and TOT decline dramatically, as was the case during the Dot.Com bubble and Great Recession, in the year a recession is declared. A recession’s impact on Property Taxes, however, lags behind the other categories by approximately 2 years as it takes considerable time for the County Assessor to reflect residential and commercially assessed valuations downward. Staff’s assumptions for economically sensitive revenues in this alternative scenario are as follows:  Documentary Transfer Tax: declines by 8.5% or $0.6 million in FY 2018 followed by another decline of 22.4% or $1.5 million in FY 2019.  Sales Tax: declines 11.8% or $3.5 million in FY 2019 and by another 5.0% or $1.3 million in FY 2020.  Transient Occupancy Tax: declines by 11.5% or $3.1 million in FY 2019 and dips further in FY 2020 by 4.6% or $1.1 million  Property Tax: Palo Alto has been fortunate in past recessions with property taxes plateauing rather than declining. Beginning in FY 2019, staff expects revenues to level off at $43.0 million and stay at this level through FY 2021. Conclusion The Long Range Forecast projects a slight General Fund surplus of $0.1 million for FY 2017 and, except for a budget shortfall in FY 2018, reflects a generally positive outlook over the next 10 years. Economic indicators demonstrate that the local business environment is rebounding; however, substantial financial obligations and added uncertainties may diminish the General Fund surplus over the next 10 years. Despite improving revenue receipts as projected forward, the City continues to face challenges related to the funding of infrastructure, the desire to retain and attract a talented workforce, being responsive to the City Council priorities and the community expectations, rising benefits costs, and unfunded long-term pension and retiree healthcare liabilities in the amount of $439 million. Additionally, as an Alternative Forecast Model shows, the City needs to be prepared for the next recession. Having healthy reserves and a potential separate pension trust plan to offset a recession impact will be critical in order to have a future budget that allows staff and the City Council at least a year to plan for permanent budget adjustments. While the City is addressing these short and long-term issues, the City needs to continue reviewing its operations and service delivery options. Over the last few years, the City has outsourced services to the private sector and entered into negotiations with the non-profit sector for public-private partnerships. Staff is engaged in finding a partner to effectively and efficiently operate Animal Services and is exploring different service delivery options for the City’s aquatic operations While the City further explores alternative service delivery models with the goal to reduce staff levels and related benefit costs, the City will also review cost recovery levels of services currently provided to the community. In early 2016, staff will bring forward recommendations to increase fees for the Planning and Community Environment Departments as well as other departments to align the fees with the cost recovery goals set by the City Council approved User Fee Cost Recovery Level Policy. City of Palo Alto Page 30 This 10-year Forecast assumes an additional $68 million to be dedicated towards the completion of infrastructure needs. Although these additional funds are substantial, they may not be sufficient to build the projects due to escalating construction costs or within existing timelines. Therefore, as prior infrastructure plans have not completely materialized to completion, it will be important to focus on maintaining the current plan as a top priority and not be tempted to increase ongoing operational expenses that surface unless they are deemed absolutely necessary in order to complete the plan. The City is currently updating its Comprehensive Plan. Staff is in the final stages of assessing the fiscal impacts of the various planning scenarios that will be used to analyze policy choices that will have to be made as part of the Comprehensive Plan Update. Once the City Council approves the Comprehensive Plan update with its inherent policy choices, revenue assumptions for future Forecasts will be aligned with the new Comprehensive Plan. During the next two months, staff will continue to monitor revenue sources as well as update revenues and expenditures, as applicable, based on newly available information. This updated information will be reflected in the FY 2017 Proposed Budget, which is scheduled to be released to the City Council late April 2016. While facing some significant unfunded financial challenges, the City is in a good position to plan accordingly and based on the diversified revenue sources it can continue to address the necessary infrastructure needs, but decisions must be prioritized and focused. Attachments:  Attachment A: Revenues (PDF)  Attachment B Expenditures (PDF) Endotes i International Monetary Fund (IMF), World Economic Outlook: Executive Summary, October 2015, Page XV ii International Monetary Fund (IMF), World Economic Outlook: Executive Summary, October 2015 iii International Monetary Fund (IMF), World Economic Outlook: Chapter 1 Recent Developments and Prospects, October 2015, Page 1 iv U.S. Department of Commerce Bureau of Economic Analysis (BEA), “National Income and Product Accounts Gross Domestic Product: Third Quarter 2015 (Second Estimate),” November 24, 2015. v UCLA Anderson Forecast, December 2015 vi UCLA Anderson Forecast, December 2015 vii Bureau of Economic Analysis (BEA), Labor Force Statistics from the Current Population Survey, December 2015 viii UCLA Anderson Forecast, December 2015 ix Bureau of Economic Analysis (BEA), Local Area Unemployment Statistics, December 2015 x UCLA Anderson Forecast, Job growth, wage increases to push real GDP growth past 3% for first time since ’05, December 2, 2015. City of Palo Alto Page 31 xi Zillow, California Home Prices & Values, Zillow Home Value Index, Accessed December 2015 xii United States Bureau of Labor Statistics (BLS), Local Area Unemployment Statistics: San Jose- Sunnyvale-Santa Clara, CA MSA, Accessed December 2015 xiii Zillow, Palo Alto Real-Estate Market Overview, Zillow Real Estate Data for Palo Alto, Accessed December 2015 Attachment A Fiscal Year 2017-2026 Base Long Range Financial Forecast - Revenues Attachment B Fiscal Year 2017-2026 Base Long Range Financial Forecast – Expenditures