G - Financial Schedules — Cupertino City Council, May 19, 2022

Financial Schedules
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Financial Overview by Fund
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Flow of Funds Chart (Sankey)
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General Fund Contribution Schedule
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Fund Balance Report
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General Fund Summary
The General Fund is the City’s primary operating fund. It accounts for basic services such as public safety, public works, planning and development, park maintenance, code enforcement, and the administrative services required to support them. The fund generates revenue from the City’s discretionary funding sources (e.g., property tax, sales tax, transient occupancy tax, and utility tax). As a rule, general fund resources are used only to fund operations that do not have other dedicated (restricted) funding sources. Operations that rely heavily upon non-general fund resources, such as street maintenance, solid waste collection, and recreation are accounted for in other funds. Information on these funds may be found in the Other Funds section of this document.

For FY 2022-23, General Fund revenue estimates are $93.7 million, a $4.0 million, or 4.5%, increase from the FY 2021-22 Adopted Budget, mostly due to an increase in sales tax and property tax.

General Fund expenditure estimates are $93.0 million, a $3.2 million, or 3.6%, increase from the FY 2021-22 Adopted Budget. The General Fund’s ending fund balance is projected to increase by 1.1% from the FY 2021- 22 Adopted Budget ending fund balance. This is due to a projected increase in sales tax, property tax, and transient occupancy taxes offset by a projected decrease in utility user's tax.

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General Fund Revenues
Estimates for the FY 2022-23 beginning fund balance and General Fund revenue sources are based upon a careful examination of collection history and paWerns as they relate to such factors as seasonality and performance in the economic environment that the City is most likely to encounter in the coming year. FY 2022-23 revenue estimates are based on the anticipated increase or decrease in activity and receipts over the current year. Each source of revenue can be inﬂuenced by external (outside of the City's control) and/or internal factors. The FY 2022-23 revenue estimates are built on the assumption of the City moving toward a recovery from the COVID-19 pandemic.

As shown in the chart below, FY 2022-23 revenues are estimated at $93.7 million, a 4.5% increase over the FY 2021-22 Adopted Budget.

Note: Revenues from Investment Fund (Fund 130) not included in table The majority of Cupertino's General Fund operating revenues are generated by sales taxes (34%) and property taxes (32%), followed by charges for services (12%) and Transient Occupancy Tax (5%). The chart on the next page illustrates the sources of General Fund revenue by category.

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The FY 2022-23 General Fund revenue estimates are discussed by category in the material that follows.

Sales and Use Tax, commonly referred to as just the "sales tax" has two components: (1) an excise tax imposed on retailers for the privilege of selling tangible personal property, and (2) an excise tax imposed on a person and applies to purchases from out-of-state vendors that are not required to collect tax on their sales. The proceeds of sales and use taxes imposed within the boundaries of Cupertino are distributed by the State to various agencies, with the City of Cupertino receiving one percent, as shown in the chart to the right. Staﬀ will continue to monitor competing interests for the City's ¼ cent sales tax imposed on local governments as a FY 2022-23 Proposed Budget
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potential new source of revenue for aﬀordable housing and transportation. If the City decides to include a similar ballot measure at a future election, subject to voter approval, the City has an opportunity to retain local control over the additional sales tax proceeds.

The City's sales tax revenues are generated from ﬁve principal economic categories: business-to-business 53% (includes electronic equipment and soNware manufacturers and distributors), state and county pools 32%, restaurants and hotels 7%, general consumer goods 4%, and fuel and service stations and other 1.6%.

Our two largest sales taxpayers in the business-to-business category represent a large part of that sector and can signiﬁcantly aﬀect sales tax trends. Corporate and business technology spending drove growth in this sector in FY 2019-20 and FY 2020-21 as businesses transitioned to remote work during the pandemic. Business- to-business sales tax is expected to decrease as pandemic restrictions end and the State transitions to a new normal. Given these trends, the City's FY 2022-23 sales tax revenue is expected to be lower than the historic highs seen in FY 2020-21.

Sales tax receipts increased by 26.1% in FY 2016-17 due to a one-time $3.5 million payment related to the closeout of the triple ﬂip and took a slight dip of 2.8% in FY 17-18. Additionally, the City's sales tax revenues spiked to historic highs in both FY 2019-20 and FY 2020-21; however, the City is considering it one-time. Sales tax revenues are estimated to generate $32 million in FY 2022-23, up 14.7% from the FY 2021-22 Adopted Budget.

The swiN reaction by consumers and businesses to the outbreak of COVID-19 in 2020 created signiﬁcant ﬂuctuations for the City's industry groups. While restaurants and hotels, general consumer goods, and automotive industry groups were severely impacted, the City's business-to-business and County pool allocation share increased substantially. This was brought on by shelter-in-place mandates throughout the State, which reduced sales tax revenues for restaurants and brick and mortar retail; thereby increasing online sales. Additionally, the conversion to remote work increased the demand for computer and electronic equipment, which also increased the City's sales tax revenues. As the State continues toward recovery and businesses continue their opening, it is anticipated that the City's restaurant and hotels, general consumer goods, and automotive industry groups will recover and increase. However, these increases will only slightly mitigate the anticipated declines in the City's business-to-business and County pool share allocation as online sales fall from recent historic highs. Although there is much uncertainty about the City's sales tax revenues, the City anticipates positive annual sales tax increases in the future. As information and data continue to become available, staff will bring forth updates and adjustments regularly as necessary.

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Under current law, property is assessed at actual full cash value with the maximum levy being 1% of the assessed valuation. The assessed value of real property that has not changed ownership can be adjusted by the change in the California Consumer Price Index (CCPI) up to a maximum of 2% per year. Property that changes ownership, property that is substantially altered, newly-constructed property, State-assessed property, and personal property are assessed at the full market value in the ﬁrst year and subject to the two percent cap, thereafter.

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In 1978, voters approved the passage of Proposition 13, which froze property tax rates and limited the amount that rates could increase each year. Cupertino had one of the lowest property tax rates in Santa Clara County receiving only $0.02 for every $1.00 paid. Subsequent legislation required Counties to provide "no/low tax" cities with a Tax Equity Allocation (TEA) equal to 7% of the property tax share, however, the property tax distribution for the no/low tax cities in Santa Clara County was limited to 55% of what other TEA cities in the State received.

Property Tax
In FY 2006-07 West Valley cities won the passage of State legislation which restored a portion of TEA property tax revenue. This TEA change provided an additional $1.35 million in property tax annually and increased the City's share of property taxes to 5.6%. In conjunction with three other West Valley cities, Cupertino continued legislative eﬀorts to gain parity with other no/low property tax cities in the State. In FY 2015-16, Governor Brown agreed to restore TEA revenues over a ﬁve-year period. In FY 2019-20 TEA was fully restored, and Cupertino kept approximately 7.0% of property tax revenues in FY 2019-20 compared to 6.72% in FY 2018-19.

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Additionally, Educational Revenue Augmentation Fund (ERAF), a mechanism enacted in July of 1992 by the State Legislature to shiN local tax revenues from cities, counties, and special districts to a State control ERAF, absorbs the shift-back of the TEA.

The City experienced a net taxable value increase of 3.5% for the 2021-22 tax roll. The bulk of the increase was due to increases in residential properties by $829 million, or 4.9%. This category makes up 61.1% of the net taxable value. Unsecured property tax decreased by $700 million, or 28.9%. This category makes up 6.0% of the net taxable value. Lastly, commercial property values increased by $573 million, or 7.6%. This category makes up 28.3% of the net taxable value. The eﬀects of COVID-19 on housing prices in Cupertino and the Bay Area have yet to be seen. Although values continue to increase, staﬀ will monitor the potential impact of long-term and even permanent remote work in the City and region.

Transient occupancy taxes (TOT) are levied on hotels and short-term room rentals located in the City at the rate of 12% of room revenues. In November 2011, 83% of voters approved increasing the rate from 10% to 12%. This rate increase contributed to the upward trend shown in the TOT Historical Trend graph. TOT is expected to end FY 2021-22 at $3 million, a 40% increase from FY 20-21 actuals. The anticipated increase is due to the recent relaxation of prior pandemic-based restrictions, allowing for increased travel and the return of employees to their places of work.

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TOT is projected to increase 66.7% in FY 2022-23. The City anticipates a "full-recovery" of TOT by FY 2023-24; however, the extent of the recovery is uncertain as the eﬀect of teleworking on business travel remains to be determined. Currently, a recovery to a $7.5 million level is anticipated by FY 2023-24. With a Proposed Budget amount in FY 2022-23 of $5 million, it is clear the recovery in travel will gradual; however, staﬀ are cautiously optimistic that this recovery could be accelerated through the continued roll out of the COVID-19 vaccination.

Staﬀ will continue to monitor these activities and bring forward adjustments and recommendations as necessary.

The utility user tax (UUT), approved by voters in 1990, is assessed on gas, electricity, and telecommunication services provided within the City’s jurisdiction at a rate of 2.4% of billed charges. Revenues generated from this tax can be used for general City purposes.

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The City's tax rate is generally lower than that of other cities within Santa Clara County, as shown in the chart above. In March 2002, voters approved extending the utility tax's sunset date from 2015 to 2030. This extension corresponded with the extended debt maturity date resulting from the reﬁnancing of debt for capital improvement projects. To maintain tax revenues currently received from telecom services, voters passed a measure in 2009 to update the ordinance to the changing technology in this area.

FY 2021-22, UUT revenues are estimated to increase 5.6% from FY 2020-21 actuals, with projected revenues of $3.2 million due to more revenue generated from utilities being used. Budgeted revenues are expected to decrease to $3 million in FY 2022-23. This revenue source will be monitored closely as the ﬁscal year progresses.

Franchise fees are received from cable, solid waste, water, gas, and electricity franchisees that operate in the City. The fees range from 1% to 12% of the franchisee's gross revenues depending on each agreement. As shown in the graph below, these revenues are relatively steady and not sensitive to economic fluctuations.

In FY 2021-22, franchise fee revenues are trending up 0.3% from FY 2020-21 actuals primarily due to an increase in electricity and water rates. Budgeted revenues are expected to remain at approximately $3 million for FY 2022-23. This revenue source will be monitored closely as the fiscal year progresses.

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Other taxes are comprised mainly of business license taxes, construction taxes, and property transfer taxes. As shown in the graph, business license and property transfer taxes are relatively steady while construction taxes are extremely volatile and sensitive to economic fluctuations.

With the inﬂux of several major construction projects beginning in 2012, revenues began increasing. The largest of the projects included the Apple Park and Main Street developments. These projects coupled with a strong housing recovery created a record year for revenues in FY 2013-14. These revenues have since returned to historic levels. In FY 2022-23, these revenues are expected to increase by 43% from the prior year to $1.8 million.

This is primarily due to the projected increase from known 2021 property tax transfers. For years 2023-24 and later a growth rate is applied that is representative of the historical average rate of real property growth due to properties that have transferred ownership.

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This category accounts for charges to users of City services funded by the General Fund as well as internal City-wide overhead. The City aWempts to recover the cost of the services, including planning, zoning, and engineering permit processing for new property development as well as some recreation-related fees. As such, this revenue source is sensitive to economic ﬂuctuations, as shown in the graph below. Apple Park and other large developments generated large one-time revenues in FY 2013-14 as well as FY 2015-16 and FY 2016-17.

In addition, beginning in FY 2013-14, enterprise funds, internal service funds, and special funds began charging for overhead services previously subsidized by the General Fund. Some internal strategic support services (Human Resources, Finance, City Clerk, etc.) also began charging internal departments for their services to capture the true cost of providing various programs and services within City operations. ANer a comprehensive cost allocation plan (CAP) was approved by Council in April 2016, internal strategic support services (City Council, Facilities, Maintenance, etc.) were included. In FY 2015-16, the City's administration changed its methodology for tracking developer deposits driven by increased developer activity and, as a result, both budgets for revenues and expenses were increased by anticipated deposit amounts leading to another large increase in revenue.

Current year actuals will come in higher compared to budgeted levels due to relaxation of prior pandemic restrictions, allowing for the continued reopening of City facilities. Increases in the City fees (expected to be eﬀective July 2022) would represent additional revenues of approximately $92,662 in the General Fund and $158,000 in the Enterprise Funds. As the City moves toward recovery, growth in charges for services revenues is anticipated in FY 2022-23.

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Licenses and permits include fees for reviewing building plans, building inspections, construction, tenant improvements, and commercial/residential installations for compliance with state and municipal building codes.

The Apple Park project and large residential projects (Rosebowl, Biltmore expansion, Main Street) generated signiﬁcant permiWing revenues in FY 2013-14. Since then, activity has slowed until FY 2018-19 when revenues came in 48.8% higher. Although this revenue source is relatively consistent from year to year, ﬂuctuations may occur depending on the timing of projects being completed. The $33.5 million estimated amount in FY 2021-22 is due to Vallco Town Center (renamed The Rise) and its scheduled commencement in FY 2022-23. Vallco's commencement was originally scheduled in FY 2020-21 and FY 2021-22 but was postponed due to soil contamination. These revenues will be carried forward and recognized as the project progresses to completion.

This revenue source is expected to reach $3.5 million in FY 2022-23.

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The use of money and property category is comprised of General Fund interest earnings as well as facility and concession rental income of City-owned property. The City's portfolio is approximately $171.2 million.

Fluctuations in this revenue category are a result of investment earnings, as rental income is fairly steady.

Investment earnings were higher in FY 2019-20 and FY 2020-21 due to investment gains in the City’s Section 115 Pension Trust.

Investment earnings are a function of the amount of cash available for investment, current interest rates, and composition of investments. The City's investment objectives, in order of priority, are:

Safety to ensure the preservation of capital
Sufficient liquidity for cash needs
A market rate of return consistent with the investment program Geopolitical conﬂict has fueled volatility in ﬁnancial markets. The conﬂict has exacerbated inﬂationary pressures, particularly in energy and commodities, and has caused tightening conditions in ﬁnancial markets.

While consumer spending and economic growth remain strong, an extended conﬂict along with elevated energy prices increases the risk of an economic fslowdown later this year. While the Federal Reserve is expected to tighten monetary policy, the Federal Open Market CommiWee (FOMC) has very liWle margin for error as it aWempts to combat inﬂation without pushing the economy into a recession. Over the near-term, the City's investment manager, Chandler Asset Management, expects ﬁnancial market volatility to remain elevated and conditions to remain tighter with heightened geopolitical risk, supply chain boWlenecks and persistent inflation, and the Federal Reserve's pivot to less accommodative monetary policy.

The FOMC raised the federal funds rate by 0.25% at their March 16th meeting to a target range of 0.25% to

0.50%. The Federal Reserve also ended their bond-buying program as expected in March, which included the purchase of treasury and agency mortgage-backed securities. Federal Reserve Chair Powell suggested that balance sheet runoﬀ could begin as early as their next meeting in May, sooner than previously anticipated, and that the pace of the unwind will likely be faster than in the previous quantitative tightening cycle. The dot plot favors six additional rate hikes in 2022, which implies a 25 basis point rate hike at each remaining meeting this year, but the Federal Reserve hasn't ruled out incorporating one or more 50 basis point hikes to address inflation.

City staﬀ will continue to monitor interest rates as well as economic factors in both the local as well as the national economy.

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Fines and forfeitures account for revenues generated from vehicle, parking, and miscellaneous code violations issued by the County Sheriﬀ and the City's Code Enforcement oﬃcers. In FY 2021-22, the revenues for City Fines were inadvertently excluded, reﬂecting a projected estimate of only $225,000. However, aNer adding an estimated $102,000 in revenues for City Fines, this revenue source is expected to reach $327,000 in FY 2021-22.

Additionally, FY 2022-23 revenues are expected to increase to $427,000 due to an increase in ﬁnes as society rebounds from the pandemic.

Intergovernmental revenues are made up of federal, State, and regional grants, including miscellaneous intergovernmental revenue. FY 2021-22 actuals are estimated to come in signiﬁcantly higher than budgeted levels due to the receipt of COVID-19 relief dollars as part of the American Rescue Plan Act of 2021. The City received $4,852,301 in FY 2020-21 and is expecting to receive $4,852,301 in FY 2021-22.

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Miscellaneous revenues account for unanticipated revenues such as donations

and administrative fees. FY
2022-23 miscellaneous revenue remains relatively consistent with FY 2021-22 Adopted Budget. FY 2021-22 miscellaneous revenue is estimated to come in higher than budgeted due to a $500,000 increase in administrative fees for Community Development Department projects .

These revenues will be carried forward
and recognized as the project progresses to completion.

The majority of the General Fund's miscellaneous
revenues are due to Apple's annual donation for additional sheriff services at Apple Park.

Other Financing Sources generally account for refundable deposit revenues within the Community Development Department. With signiﬁcant ﬂuctuations year-over-year, staﬀ conservatively estimate these revenues. In FY 2021-22, revenues are projected to be higher due to the carryover of refundable deposit revenues for development projects. This revenue source is expected to remain at $275,000 in FY 2022-23.

Transfers In represent the movement of funds from one City fund to another, the General Fund in this case. In the FY 2021-22, actual transfers were higher due to $4.8 million in transfers related to the American Rescue Plan Act. In FY 2022-23, the City plans to transfer $15,000 from the City's Tree Fund to the General Fund to support ongoing tree maintenance operations.

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General Fund Expenditures
Estimates for the FY 2022-23 General Fund expenditures are based upon anticipated personnel and non- personnel cost increases. This year, department budgets reﬂect a base budget with justiﬁed ongoing expenses, accounting for changes in personnel costs and any other anticipated/known increased costs in FY 2022-23. In addition, most budgets were given additional funds for any unexpected expenditures that are accounted for in the contingency account, which remained at 2.5% of base materials and contract services. Lastly, per the City’s Reserve policy, an unassigned General Fund balance above the $500,000 maximum balance will be recommended for transfer to the Capital Reserve Fund for future capital and infrastructure projects, aNer year- end close and as part of the mid-year financial report.

With a projected increase in unassigned fund balance for FY 2022-23 and an unexpected increase in revenues during FY 2020-21 and FY 2021-22, the City is recommending adding back a number of prior year materials and contract services requests that were deferred to mitigate the impacts of COVID-19. Additionally, ﬁnancial updates will be provided on a quarterly basis to eﬀectively communicate the City's progress toward a ﬁnancial recovery from COVID-19.

As shown in the chart on the next page, FY 2022-23 expenditures are estimated at $93.0 million, which represents a 4% increase compared to the adopted budget from the prior year. This budget reﬂects an increase in Employee Compensation and Beneﬁts due to negotiated salary and beneﬁt changes as well as increased retirement costs. There is also an increase in Materials primarily aWributed to an increase in soNware expenses, electrical, and water service charges in FY 2022-23. Additionally, there is an increase in Contract Services primarily aWributed to the annual increase in the City’s Law Enforcement contract with Santa Clara County Sheriff.

The largest General Fund operating expenditure categories include Employee Compensation and Beneﬁts (38%), Contract Services (27%), Transfers Out (13%), and Cost Allocation (11%) as illustrated in the FY 2022-23 General Fund Expenditures by Category chart.

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Personnel Costs
Personnel costs total $35.2 million in FY 2022-23, comprising 38% of General Fund expenditures. These costs are made up of salaries and compensation for beneﬁWed and part-time staﬀ (68%), retirement beneﬁts (20%), and other fringe benefits (11%), including health coverage.

Costs were calculated by taking an extract of payroll system information. This individual position-level information was then reviewed, corrected, and updated by each department to include current vacancies and ﬁlled positions, accurate salary step status, as well as any position reallocations. Also, all categories of beneﬁt costs in the coming year were projected. The most recent retirement plan and health plan information for each position was also updated from the payroll system. Not included in personnel costs is the ongoing contribution for retiree healthcare which is included in the transfers category.

CalPERS retirement rates are projected to increase to $6.9 million, an increase of $0.7 million, or 11.5%, per the most recent actuarial valuation report from CalPERS. Under the Funding Risk Mitigation Policy, the 21.3% return in FY 2020-21 triggered a reduction in the discount rate from 7% to 6.8%. Pension contribution projections are reflected in the General Fund forecast section of the budget.

A total of 223 FTEs are proposed in FY 2022-23, an increase of 12 FTEs, or 5.7%, from the FY 2021-22 Amended Budget. The positions are summarized below:

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Non-Personnel
Non-personnel costs total $45.9 million in FY 2022-23, comprising 49% of General Fund budgeted appropriations. These costs are primarily made up of Contract Services (27%), Cost Allocation charges (11%), Materials (8%), and Capital Outlays and Special Projects (2%). Costs were developed from the base budget created in FY 2021-22 with justiﬁed ongoing expenses and adjustments for any other anticipated/known increased costs in FY 2022-23. One-time projects were moved to a separate category in FY 2013-14 to ensure that expenditure trends reﬂect ongoing expenditure needs. In FY 2017-18, a concerted eﬀort was made to diﬀerentiate costs related to special projects and capital outlays that are required to be depreciated. A special projects series was created in the contracts section of accounts for any new special projects going forward.

With a projected increase in total unassigned fund balance for FY 2022-23, the City is able to add back a number of FY 2021-22 materials and contract services that were cut due to COVID-19 which is reﬂected in the 9% increase in materials and 5% increase in contract services compared to the prior year. Although program contingencies will remain reduced from 5% of budgeted General Fund materials and contract services to 2.5%.

Program contingencies have been allocated proportionately among operating programs based on each program’s share of General Fund budget for materials and contract services. The City Manager Contingency is the second level of contingency established for unexpected expenditures that may occur over the program contingency. In FY 2020-21, the City Manager Contingency was reduced from 2.5% of budgeted General Fund materials and contract services to $75,000. This brings total contingencies for the General Fund to approximately 2.5% of budgeted materials and contract services. This percentage is lower than the best practices adopted by the Governmental Accounting Standards Board (GASB) which recommended 5-15% contingency. Program contingency budgets may be used to cover unanticipated program expenses at the department’s discretion, while the use of the City Manager Contingency will require City Manager approval.

The Sheriff’s contract is excluded from the contingency calculation.

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General Fund Transfers
Transfers out represent transfers of monies out of the General Fund to various other funds. These transfers provide resources to the receiving fund to support operating and capital expenditures. For FY 2022-23, the following transfers are proposed.

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General Fund Fund Balance
As prescribed by GASB Statement No. 54, governmental funds report fund balance in classiﬁcations based primarily on the extent to which the City is bound to honor constraints on the speciﬁc purposes for which amounts in the funds can be spent. Fund balances for governmental funds are made up of the following:

Nonspendable Fund Balance
– includes amounts that are (a) not in spendable form, or (b) legally or contractually required to be maintained intact. The “not in spendable form” criterion includes items that are not expected to be converted to cash, for example, prepaid items, property held for resale, and long-term notes receivable.

Restricted Fund Balance
– includes amounts that can be spent only for the speciﬁc purposes stipulated by external resource providers, constitutionally or through enabling legislation. Restrictions may eﬀectively be changed or lifted only with the consent of resource providers.

CommiHed Fund Balance
– includes amounts that can only be used for the speciﬁc purposes determined by formal action of the City’s highest level of decision-making authority, the City Council. Commitments may be changed or liNed only by the City taking the same formal action (resolution) that imposed the constraint originally.

Assigned Fund Balance
– comprises amounts intended to be used by the City for speciﬁc purposes that are neither restricted nor commiWed. The intent is expressed by the City Council or oﬃcial to which the City Council has delegated the authority to assign amounts to be used for speciﬁc purposes. Through the adopted budget, the City Council establishes assigned fund balance policy levels and also sets the means and priority for the City Manager to fund these levels.

Unassigned Fund Balance
– is the residual classiﬁcation for the General Fund and includes all amounts not contained in the other classifications. Unassigned amounts are technically available for any purpose.

In circumstances when an expenditure may be made for which amounts are available in multiple fund balance classiﬁcations, the fund balance in General Fund will generally be used in the order of restricted, unassigned, and then assigned reserves. In other governmental funds, the order will generally be restricted and then assigned.

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General Fund Classification of Fund Balance
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All Funds Summary
This section provides information on the FY 2022-23 Special Revenue, Debt Service, Capital Project, Enterprise, and Internal Service Funds budgets including, expenditure and revenue highlights, transfers to other funds, reserve funds, and the financial forecast.

Revenue Estimates
Estimates for FY 2022-23 fund balance and individual revenue accounts are based upon a careful examination of the collection history and paWerns as they relate to such factors as seasonality and performance in the economic environment that the City is most likely to encounter in the coming year. Each source of revenue can be inﬂuenced by external (outside of the City’s control) and/or internal factors. The FY 2022-23 revenue estimates are built on the assumption that the economy will experience conservative growth as society recovers from the pandemic.

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Special Revenue Funds
Special Revenue Funds account for the proceeds of speciﬁc revenue sources that are legally restricted to expenditures for speciﬁc purposes. Special Revenue Funds include the Park Dedication, Transportation, Storm Drain, and Environmental Management/Clean Creeks funds.

Revenue
Revenue sources are projected to increase by $3.5 million. Increases in taxes are oﬀset by decreases in transfers from the General Fund. Other Taxes is increasing due to housing mitigation revenue from the oﬃce project at 19191 Vallco Parkway. Transfers are decreasing because the Capital Improvement Program is not included in the Proposed Budget. The Capital Improvement Program will be considered in a separate study session and included in the Adopted Budget.

Expenditures
Expenditure uses are projected to decrease by $13.3 million primarily due to a decrease in Capital Outlays because the Capital Improvement Program is not included in the Proposed Budget.

Fund Balance
Fund balance represents fund savings and is calculated by taking the beginning balance and then adding the diﬀerence between revenue and expenditures to arrive at the ending fund balance. It is projected to increase by $4.7 million due to an increase in housing mitigation revenue from the office project at 19191 Vallco Parkway.

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Debt Service Fund
The Debt Service Fund provides for the payment of principal, interest, and associated administrative costs incurred with the issuance of debt instruments for the City’s Public Facilities Corporation. The budget funds the Corporation’s annual payment of principal and interest on the City Hall/Community Hall/Library Certificates of Participation (COP) that will be paid off by July 1, 2030.

On September 29, 2020, the City’s 2020A Certiﬁcates of Participation (2020 COPs) were successfully sold in order to refund the City’s 2012 Certiﬁcates of Participation for debt service savings. The refunding generated net present value savings of approximately $3.14 million, 11.61% of refunded par, and a True Interest Cost of

0.72%. Savings to the City’s General Fund amounts to approximately $494,000 per year for the next 10 years or almost $5 million in total savings.

Revenue
Revenue sources are relatively unchanged from the last ﬁscal year. The $2.7 million transfer from the General Fund funds the annual payment of principal and interest for the City’s debt. Increased activity in FY 2020-21 is due to the refinancing.

Expenditures
Expenditure uses are relatively unchanged from last ﬁscal year. The $2.7 million in expenditures represents the annual payment of principal and interest for the City’s debt. Increased activity in FY 2020-21 is due to the refinancing.

Fund Balance
Fund balance represents fund savings and is calculated by taking the beginning balance and then adding the diﬀerence between revenue and expenditures to arrive at the ending fund balance. Fund balance is relatively unchanged from last fiscal year.

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Capital Project Funds
This fund pays for the acquisition of major capital facilities and/or construction of major capital projects.

Revenue
Revenue sources are projected to decrease by $21.5 million because the Capital Improvement Program is not incorporated into the Proposed Budget. The Capital Improvement Program will be presented to City Council in a separate study session and included in the Adopted Budget. Transfers from the General Fund to the Capital Reserve are budgeted for this year. In the past, transfers to the Capital Reserve were not budgeted and instead adjusted at mid-year. Given the City's aging infrastructure and capital projects needs, the City is allocating $2.5 million in transfers annually to the Capital Reserve throughout the forecast to facilitate Capital Improvement Program budget forecasting.

Expenditures
Expenditure uses are projected to decrease by $20.3 million because the Capital Improvement Program is not incorporated into the Proposed Budget. The $175,000 is budgeted for annual capital project planning and support.

Fund Balance
Fund balance represents fund savings and is calculated by taking the beginning balance and then adding the diﬀerence between revenue and expenditures to arrive at the ending fund balance. It is projected to decrease by $2.3 million because the Capital Improvement Program is not incorporated into the Proposed Budget.

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Enterprise Funds
Enterprise Funds are set up for the provision of speciﬁc services that are funded directly by fees charged for those goods or services. Enterprise Funds include the Resource Recovery, Sports Center, Blackberry Farm Golf Course, and Recreation funds.

Revenue
Revenue sources are projected to decrease by $0.9 million due to a decrease in fees and a decrease in transfers from the General Fund. Fee revenue estimates are conservative as the timing and extent of recovery to pre- COVID level activity are difficult to measure.

Expenditures
Expenditure uses are projected to decrease by $2.0 million due to a decrease in cost allocation charges and a decrease in special projects.

Net Position
Enterprise funds carry net position instead of fund balance. Net position is calculated by taking the beginning balance and then adding the diﬀerence between revenue and expenditures to arrive at the ending net position.

However, some of these resources are not liquid and represent capital assets. These monies are generally accumulated to support capital replacement and/or expansion needs. It is projected to decrease by $2.8 million due to decreased revenues and transfers.

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Internal Service Funds
Internal Service Funds are used for areas where goods or services are provided to other departments or governments on a cost-reimbursement basis. Internal Service Funds include the Information & Technology, Vehicle & Equipment Replacement, Workers' Compensation, Compensated Absences & Long-Term Disability, and Retiree Medical funds.

Revenue
Revenue sources are projected to increase by $1.1 million due to increased transfers from the General Fund for IT costs.

Expenditures
Expenditure uses are projected to increase by $0.1 million.

Net Position
Internal Service Funds carry net position instead of fund balance. Net position is calculated in the same manner as fund balance, taking the beginning balance and then adding the diﬀerence between revenue and expenditures to arrive at the ending net position. However, some of the resources are not liquid and represent capital assets. These monies are generally accumulated to support capital replacement and/or expansion needs.

It is projected to decrease by $1.6 million due to revenues being higher than expenditures. Expenditures are increasing due to a technology refresh.

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General Fund Forecast
Overview
City staff develops medium-term (5-year) and long-term (20-year) forecasts as part of the budget process. While long-term projections are inherently less reliable than short-term projections, they can help detect structural budget issues early. As shown in the following chart, revenues will start to fall short of expenditures in FY 2040-41 because revenues are growing slower than expenditures.

Revenue growth is primarily driven by sales, property, and transient occupancy taxes.

Sales tax revenues experienced tremendous growth in FY 2019-20 and FY 2020-21 as the pandemic lead to increases in business-to-business and online sales. Sales tax is expected to be lower in FY 2022-23 compared to FY 2020-21 as the State emerges from the pandemic. In addition, the California Department of Tax and Fee Administration (CDTFA) is currently auditing the City's sales tax revenues. The impact of this audit is unknown but has the potential to have a signiﬁcant impact on the City’s sales tax revenues. Once more information is known, staff will bring updates to Council.

Property tax—while currently strong—may be aﬀected if telecommuting impacts property values in the Bay Area.

Transient occupancy tax revenues have been slow to recover and are expected to gradually recover to 75% of pre-pandemic levels. Telecommuting may reduce business travel, reducing the demand for City hotels.

Expenditure growth is primarily driven by:

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Requests for additional staffing to meet the demand for City services.

Increases in the City’s Law Enforcement contract with the Santa Clara County Sheriff’s Office.

Revenues continue to grow at a slower pace than expenditures, with annual operating surpluses projecting to decrease, as shown below.

Although it is diﬃcult to estimate the full impacts of COVID-19 long-term, the City’s ﬁscal foundation remains strong. With the General Fund’s Economic Uncertainty Reserve intact and a healthy unassigned fund balance, the City is poised to withstand the impacts of revenue volatility. As the City emerges from the pandemic, staﬀ will continue to closely monitor the situation and adjust when necessary. Staﬀ intends on keeping the City Council and community informed with regular updates. Having the latest information and up-to-date data will allow for informed decision-making.

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Forecast Methodology
A ﬁnancial forecast is a planning tool that helps staﬀ identify trends and anticipate the long-term consequences of budget decisions. The forecast is instrumental in modeling the eﬀects of retirement costs, employee compensation, and revenues on the City’s budget.

The forecast is not a plan but a model based on cost and revenue assumptions updated regularly as new information becomes available. Of these components, cost projections, which are based on known costs, are relatively reliable. On the other hand, revenue forecasts are based on assumptions related to future economic conditions, which are fraught with uncertainty. Economic forecasts change frequently and demonstrate the diﬃculties of commiWing to a particular prediction of the future. For this reason, staﬀ updates the forecast regularly.

While economic conditions are the primary drivers for economically sensitive revenues such as sales tax and property tax, other factors drive non-economically sensitive categories such as utility user taxes and franchise fees. These revenue categories are more heavily impacted by utility rate changes, energy prices, and consumption levels. Collections from local, state, and federal agencies are primarily driven by grant and reimbursement funding available from these agencies. As a result, these revenues experience no signiﬁcant net gain or loss during economic expansions or slowdowns. All revenue projections are based upon a careful examination of the collection history and patterns related to seasonality and the economic environment the City is most likely to encounter in the future. Staﬀ also considered potential COVID-19 impacts in determining the most reasonable estimated figures.

A discussion of both the national and local economic outlooks used to develop the revenue estimates for the FY 2022-23 forecast is included below. To create the revenue forecasts, the City reviewed national, state, and regional economic forecasts from multiple sources, including the Congressional Budget Oﬃce, California’s Legislative Analyst’s Oﬃce (LAO), and the Center for Continuing Study of the California Economy (CCSCE).

To develop the sales tax, property tax, and transient occupancy tax (TOT) revenue projections, the City worked with HdL Companies, a tax consultant.

The City's Consumer Price Index (CPI) forecasts are an average of State and County CPI from:

UCLA Anderson Forecast for the Nation and California
California Department of Transportation’s California County-Level Economic Forecast In 2019, the City worked with UFI (Urban Futures, Inc.), a financial advisory and consulting firm, to:

Review, update, and enhance the City’s baseline financial forecast.

Evaluate fiscal strategies including potential local revenue measures.

Develop capital financing options, structures, and estimates for identified projects.

Prepare an analysis of city charter costs/benefits related to fiscal activities.

This forecast includes the updates and enhancements that UFI has made to the City’s baseline ﬁnancial forecast.

National Economic Outlook
Real gross domestic product (GDP) increased at an annual rate of 6.9 percent in the fourth quarter of 2021, following an increase of 2.3 percent in the third quarter. The increase was revised down 0.1 percentage points from the "second" estimate released in February. The acceleration in the fourth quarter was led by an acceleration in inventory investment, upturns in exports and residential ﬁxed investment, and an acceleration in consumer spending. In the fourth quarter, COVID-19 cases resulted in continued restrictions and disruptions in the operations of establishments in some parts of the country. Government assistance payments in the form FY 2022-23 Proposed Budget
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of forgivable loans to businesses, grants to state and local governments, and social beneﬁts to households all decreased as provisions of several federal programs expired or tapered off.

Geopolitical conﬂict has fueled volatility in ﬁnancial markets. The conﬂict has exacerbated inﬂationary pressures, particularly in energy and commodities, and has caused tightening conditions in ﬁnancial markets.

While consumer spending and economic growth remain strong, an extended conﬂict along with elevated energy prices increases the risk of an economic slowdown later this year. While the Federal Reserve is expected to tighten monetary policy, the Federal Open Market CommiWee (FOMC) has very liWle margin for error as it aWempts to combat inﬂation without pushing the economy into a recession. Over the near term, the City’s investment manager, Chandler Asset Management, expects ﬁnancial market volatility to remain elevated and conditions to remain tighter with heightened geopolitical risk, supply chain bottlenecks and persistent inflation, and the Federal Reserve’s pivot to a less accommodative monetary policy.

As the City moves forward through the pandemic and more information becomes available, staﬀ will bring forward updates and adjustments to City Council regularly as necessary.

Cupertino Economic Outlook
Despite strong economic performance continuing in Silicon Valley and Cupertino pre-COVID, data from the State of California Employment Development Department indicates signiﬁcant impacts resulting from the virus.

Due to the timing of property appraisals entering the assessor’s role, the City does not anticipate signiﬁcant impacts to property tax revenues in FY 2022-23. Property tax, while stable currently, could be aﬀected if remote work impacts property values in the Bay Area. Although strong in previous years, construction activity will continue to ﬂaWen out as recent large development projects, notably Apple Park, are now complete. Given the level of volatility surrounding the pandemic, it is diﬃcult to estimate the timing of signiﬁcant projects that could positively impact the City’s revenues.

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Revenues
The City’s top three revenue sources continue to be property tax, sales tax, and transient occupancy tax (TOT).

While this will continue to be true, the City expects revenues to be below the highs in FY 2020-21.

As shown in the chart below, General Fund revenues are expected to be $93.7 million in FY 2022-23 and increase through the forecast. Sales tax is projected to decrease from the record highs of FY 2020-21. Transient occupancy tax is projected to recover to a new normal gradually. Property tax is anticipated to increase in FY 2022-23. Other revenue sources consider assumptions ranging from no growth to conservative growth.

The National Bureau of Economic Research (NBER), an American private nonproﬁt research organization, deﬁnes the beginning and ending dates of recessions. The NBER deﬁnes a recession as "a signiﬁcant decline in economic activity spread across the economy, lasting more than two quarters which is 6 months, normally visible in real gross domestic product (GDP), real income, employment, industrial production, and wholesale- retail sales. Since World War II, recessions have lasted an average of 11.1 months and have occurred, on average, about every 58.4 months (4.8 years). As a result, the forecast assumes a recession every 4 years where revenues remain flat while expenditures continue to increase.

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Sales Tax
Sales tax is the City’s largest revenue source. Sales taxes are collected at the point of sale and remiWed to the California Department of Tax and Fee Administration (CDTFA), formerly the Board of Equalization. The CDTFA allocates tax revenue owed to the City in monthly payments.

Sales tax revenues increased signiﬁcantly in FY 2020-21 due to increases in the City’s business-to-business industry and online sales. Business-to-business revenues reached record highs as businesses transitioned to remote work as a result of the pandemic. Additionally, due to Shelter-in-Place orders, brick and mortar retail sales decreased while online sales increased. However, the City believes this increase is one-time in nature due to the pandemic.

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As the economy recovered from the depths of the pandemic, sales tax revenues from the general consumer goods, restaurants and hotels, and fuel and service stations industries rose in FY 2021-22. However, the future growth rate for sales tax revenue is expected to slow markedly. Surging inﬂation, a dramatic jump in the global price of crude oil due to geopolitical conﬂict, and the Federal Reserve’s tightening monetary policy will be headwinds in 2022. This is expected to result in weakening consumer sentiment and continued, but decelerating, sales tax growth into 2023.

In FY 2022-23, sales tax revenues are projected to be $31.9 million, a decrease from the highs in FY 2020-21.

Sales tax revenues are projected to increase by an average annual growth rate of 1.9% in the forecast. Staﬀ used conservative estimates for business and industry, general consumer goods, restaurants and hotels, and state and county pools.

The City’s sales tax revenues face concentration risk due to the dependence on a single industry. The largest industry group, business-to-business (B2B), is sensitive to economic forces. In particular, the City’s two largest sales tax sources—both technology companies—account for a large portion of the City’s total sales tax revenues. Sales tax revenue is reported two quarters in arrears, providing the City with about six months to react if this revenue starts to decline.

Another risk is the California Department of Tax and Fee Administration (CDTFA) sales tax audit. The CDTFA is currently auditing the City's sales tax revenues. The impact of this audit is unknown but has the potential to have a signiﬁcant impact on the City’s sales tax revenues. Once more information is known, staﬀ will bring updates to Council.

Given the volatility of B2B revenue, which accounts for the majority of the City’s sales tax revenue, a key goal of the City’s long-term ﬁscal strategic plan is to diversify its sales tax sources. Recently completed development projects such as Nineteen800 and Main Street have boosted retail sales and can help reduce the City’s reliance on B2B revenue.

Property Tax
Property taxes are anticipated to remain stable in the near term, but it is unknown how potential remote work might impact property taxes in the long term. With remote work, people are rethinking where they choose to live. As people no longer need to live close to the oﬃce, demand for residential real estate in urban areas may decrease. Companies can reduce oﬃce space if fewer employees are working at the oﬃce, decreasing demand for commercial office space.

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Property tax revenues are projected to be $30.0 million in FY 2022-23 and increase by an average annual growth rate of 2.5% in the forecast. This moderate forecast is based on various factors, including historical trends for the City and projections for the region. Historically, property tax has increased at an average annual growth rate of 11%. However, this moderate forecast projects a much lower growth rate because no major development projects are assumed. Major development projects, such as Main Street and Apple Park, were significant contributors to the historical growth in property tax revenues.

Transient Occupancy Tax
Transient occupancy tax (TOT) revenues fell dramatically as the pandemic reduced travel. TOT revenues were $8.9 million in FY 2018-19 and $7.3 million in FY 2019-20, falling to $2.1 million in FY 2020-21. Transient occupancy taxes rely heavily on business travel. As businesses become accustomed to remote work, business travel may be permanently aﬀected. If business travel fails to rebound, TOT revenues will be signiﬁcantly affected.

While leisure travel has recovered much sooner than expected, business travel has not recovered as quickly.

Staff is cautiously optimistic business travel will increase gradually over the next few years.

The City anticipates a recovery of TOT revenues by FY 2023-24; however, it is unknown whether business travel will return to pre-COVID levels. This forecast assumes that TOT revenues will recover to 75% of pre- COVID levels, or $7.5 million, in FY 2023-24 and gradually increase from the new normal.

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TOT revenues are projected to be $5.0 million in FY 2022-23. In the forecast, TOT is projected to increase at an average annual growth rate of 2.6%. Beginning in FY 2023-24, the City used a moderate forecast based on historical tax collections. This moderate forecast assumes slower growth than historical trends, given that no additional hotels are expected to open. De Anza Hotel and Cupertino Village Hotel are not included in the forecast as they have not been permitted yet.

TOT revenues are impacted by the tax rate charged on hotels in the City, the occupancy rate of the hotels, and the average daily room rates (ADR) of the hotels. TOT revenues are highly correlated with B2B revenue, as TOT revenues in Cupertino are primarily driven by business travel. Before the pandemic, occupancy rates were currently at record levels given the City's strong local economy. However, given the dependence on business travel, shifts in travel habits or economic conditions could significantly impact this revenue source.

Licenses and Permits
Licenses and permits are forecasted to decrease in FY 2022-23 due to reduced development activity but increase slightly in the out-years. Licenses and permits revenue is projected to grow at a rate of 0.3% each year.

Revenues are based on forecasts of California residential building permits, non-residential building permits, and construction payrolls from the UCLA Anderson Forecasts for the Nation and California. Out of prudence, this forecast does not reﬂect any major development projects that are awaiting approval. If new development projects are approved, staff will update this forecast accordingly.

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Charges for Services
Revenues from charges for services have decreased from their FY 2016-17 levels, primarily due to a decrease in development activity.

In FY 2020-21, revenues from charges for services decreased due to Parks & Recreation Department’s programs being aﬀected by the COVID-19 pandemic. During the COVID-19 pandemic, the City’s recreation facilities were shut down due to the Stay-at-Home order issued by the Santa Clara County Public Health Department in mid-March 2020. As COVID-19 restrictions have lifted, programs and events have resumed.

Charges for Services revenues are projected to increase at an average annual growth rate of 2.0%. Other Service Fees, Cost Allocation Plan Charges for Services, and General Service Fees are projected to increase by 2.8% based on full-time salary growth. Planning Fees and Engineering Fees are based on construction and development factors, including California residential building permits, non-residential building permits, and construction payrolls from the UCLA Anderson Forecasts for the Nation and California. This forecast does not FY 2022-23 Proposed Budget
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assume any major development projects that are awaiting approval.

Other Revenue
Utility taxes
are forecasted to increase by an annual average growth rate of 0.4% based on historical trends. In recent years, increases in rates have been offset by decreases in consumption.

Franchise fees
are projected to increase by an average annual growth rate of 1.7% based on a trend of historical data.

Other taxes
are made up of construction, property transfer, and business license tax revenue. Revenue is projected to increase by an average of State and County CPI.

Use of money and property

is expected to grow at a rate of 0.5% each year based on the City’s current conservative investment strategy and low-interest rates. The Section 115 Pension Trust is expected to grow at the discount rate of 6.3%.

Intergovernmental revenues
are projected to grow at a rate of 0.5% each year.

Fines and Forfeitures
are forecasted to remain constant in the forecast.

Miscellaneous revenues
are forecasted to increase by CPI each year.

Non-operational revenues (Transfers and Other Financing Sources) are not assumed in the forecast.

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Expenditures
In FY 2019-20, the City developed a zero-based budget. Staﬀ analyzed every function of the City for its needs and costs. Staﬀ built the budget starting from a zero base and justiﬁed all costs. This best practice resulted in base budget savings.

For FY 2022-23, the City updated the prior year's base budget. Materials were increased by CPI and contracts were updated based on contractual obligations. Ongoing costs that were approved during the prior ﬁscal year were also added to the base budget.

The forecast was developed based on actual expenditures in prior years and FY 2022-23 projections. The forecast also included the following factors: CPI, construction and development activity, and CalPERS Normal Cost and Unfunded Liability projections. The forecast is adjusted to account for one-time changes and budget adjustments throughout the year.

To manage expenditure growth, the City is considering budget-balancing strategies such as the use of the City’s Section 115 Trusts to fund pension and OPEB costs.

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As displayed in the chart above, General Fund expenditures are projected to be $93.0 million in FY 2022-23 and increase throughout the forecast. The main drivers of expenditure growth are employee compensation and contract services due to additional staﬃng, retirement rates, and increasing Law Enforcement costs. The following discussion focuses on the assumptions used for estimating each of the expenditure categories in the General Fund Forecast.

Personnel Expenditures
Salaries
The City is currently negotiating with its bargaining groups because labor agreements expire on June 30, 2022.

Due to the uncertainty, the forecast only accounts for step increases and changes in CalPERS retirement rates.

The forecast does not include any cost-of-living adjustments (COLA) or equity adjustments.

Employees who have yet to reach the top step in their classiﬁcation’s salary range are eligible to receive a step increase on their anniversary date. Typically, classiﬁcations have ﬁve steps, with each increase equivalent to a 5% increase in salary. Currently, approximately 41% of employees are below Step 5.

Full-time salaries are projected to grow at a rate of 2.8% per year, based on the presumed rate of growth by CalPERS. Part-time salaries are forecasted to grow at a rate of 1.5% as they generally grow slower than full-time salaries.

Health Benefits
In FY 2022-23, health beneﬁts account for about 7% of all personnel costs in the General Fund, primarily due to health insurance costs. The City pays employees a fixed amount for health and dental insurance costs instead of covering a percentage of premiums. In October 2016, City Council approved labor contracts that signiﬁcantly increased the City’s health insurance contributions to align the City with the median oﬀerings of our comparator cities. For the duration of the contract, cost increases in health and dental premiums above the negotiated amounts were fully absorbed by employees. The City is in negotiations with its bargaining groups, CEA and OE3.

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Retirement Benefits
Rising retirement costs are driving the increase in employee beneﬁts. Cupertino provides retirement beneﬁts for its employees through the California Public Employee’s Retirement System (CalPERS). Poor investment returns during the Great Recession signiﬁcantly decreased the plan’s assets. In addition, enhanced beneﬁts and actuarial assumption changes due to increased life expectancies increased the plan's liabilities. As a result, the City's pension costs have increased significantly and are one of the City's largest financial obligations.

The City’s CalPERS costs are projected to increase over the next few years, as shown in the table below.

In December 2016, the CalPERS Board of Administration lowered the discount rate from 7.5% to 7.0% with a three-year phase-in beginning in FY 2018-19 to improve the ﬁnancial stability of the pension system. This resulted in signiﬁcant increases in retirement costs. In FY 2021-22, the CalPERS Board lowered the discount rate from 7.0% to 6.8% because the FY 2020-21 investment gain of 21.3% triggered the Funding Risk Mitigation Policy.

The City’s retirement rates are based on a blend of all three tiers (2.7% @ 55, 2% @ 60, and 2% @ 62). Although employees pay a diﬀerent rate depending on their tier, the City’s costs are the same for all three tiers. The table below shows the current breakdown of City employees amongst the three retirement tiers. The majority of employees in the City are currently covered under Tier 3. Savings from the lower-cost Tier 2 and Tier 3 plans are not expected to be substantial for several years.

A retiree's highest monthly pension benefits are calculated by multiplying:

Service credit: the number of years of CalPERS service.

Benefit Factor: percentage of pay based on age.

Compensation Basis: the highest monthly average salary for a defined period.

Other Benefits
The forecast assumes health insurance, dental insurance, and vision insurance increase by CPI. No increases were forecasted for the following beneﬁts: internet allowance, standby pay, Employee Assistance Program, and Deferred Compensation. Rec Bucks are assumed to increase at a 0.5% growth rate.

Vacancy Savings
The forecast assumes vacancy savings of 5 FTE annually, based on historical vacancy rates due to attrition.

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Non-Personnel Expenditures
Non-Personnel budgets were developed based on actual expenditures in prior years and then adjusted for FY 2022-23 funding needs. In addition, one-time projects have been excluded to ensure that expenditure trends reflect ongoing expenditure needs.

For the out-years of the forecast, expenditures are projected to increase by CPI.

Materials

costs are forecasted to increase by CPI.

Contract Services
costs are projected to grow by CPI except for the Law Enforcement contract with the Santa Clara County Sheriﬀ’s Oﬃce. Law Enforcement costs are projected to grow by CPI plus 2%. Per the terms of the contract, the annual increase is limited to the lesser of:
percentage increase in total compensation and annual CalPERS cost increase or annual CPI plus 2% and annual CalPERS cost increase.

Increases in the City’s Law Enforcement costs are a primary driver of the City’s expenditure growth.

Cost Allocation
is projected to grow by 2.8%.

Capital Outlays
and
Special Projects
are projected to increase by CPI. In the last ﬁve years, the City has spent about $2 million per year in capital outlay and special project costs, excluding development projects that include pass-through revenue.

Contingencies
are projected to increase by CPI. Contingencies remain reduced in FY 2022-23. Program contingencies were cut in half to 2.5% in FY 2020-21 and the City Manager’s Contingency Fund was reduced to $75,000 in FY 2021-22. In prior years, program contingencies were 5% of Materials and Contract Services and the City Manager’s Contingency was 5% of General Fund Materials and Contract Services, excluding the law enforcement contract. The City has historically underspent in this category, and use of these funds would require pre-approval by the City Manager or his/her designee.

Transfers
represent the General Fund’s contributions to other City funds to support debt payments, pay retiree health costs, ﬁnance capital projects, replenish capital project reserves, acquire new equipment, and subsidize enterprises and operations. With the implementation of the full cost allocation plan in FY 2015-16, General Fund expenses have been shiNed to other City funds, causing some of those funds’ revenues to fall short of expenses and necessitating the use of fund balances to cover expenses. The General Fund beneﬁts in the near term from the cost shiN; however, aNer fund balances in those other funds are drawn down to minimum levels and absent aggressive revenue or cost actions in those other funds, General Fund subsidies are necessary to maintain those fund balance minimums.

Projected General Fund subsidies to each fund are based on the following assumptions:

Special Revenue Funds: $3 million annually.

Debt Service Funds: $2.7 million based on 2012 COPS debt service schedule.

Capital Reserve: $2.5 million annually.

Retiree Medical Fund: $0 million.

Compensated Absences Fund: $0.8 million and increases at a rate of 2.8% per year.

Innovation and Technology Fund: $2 million and increases at CPI per year.

Enterprise Funds: $1 million and increases at CPI per year.

In FY 2029-30, the City will ﬁnish paying oﬀ its debt for city facilities. Until FY 2029-30, the City is scheduled to pay approximately $2.7 million per year in principal and interest on the City Hall, Community Hall, and Library Certiﬁcates of Participation. The funds are transferred from the City’s General Fund to the City’s Debt FY 2022-23 Proposed Budget
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Service Funds.

Historically, the City has transferred funds from the General Fund to the Capital Reserve at mid-year. While mid-year fund transfers are typically signiﬁcant, $10 million annually on average, there has been a high degree of variability. To facilitate forecasting Capital Improvement Program funding, the forecast allocates $2.5 million annually for transfers to the Capital Reserve.

Starting in FY 2022-23, the City plans to fund Other Post-Employment Beneﬁts (OPEB) costs with the City’s Section 115 OPEB Trust because the City’s OPEB plan is over 100% funded. The OPEB Trust had a balance of $36.1 million as of March 31, 2022. Funding OPEB costs with the OPEB Trust will eliminate the transfers from the General Fund to the Retiree Medical Fund.

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Pension
CalPERS
The City provides a deﬁned beneﬁt pension to its employees through the California Public Employees' Retirement System (CalPERS). Retirement beneﬁts are calculated using a formula based on an employee’s age, earnings, and years of service. The retirement benefits are funded by:

Investment earnings (60%)
Employer contributions (29%)
Employee contributions (11%)
Each year, CalPERS determines an employer's contributions based on actual investment returns and actuarial assumptions including:

Expected investment returns (discount rates)
Inflation rates
Salaries
Retirement ages
Life expectancies
Contributions to fund the pension plan are comprised of two components:

The normal cost (the cost of the benefits earned in a respective year).

The amortization of the unfunded accrued liability (UAL).

CalPERS Discount Rate
Defined benefit plans are highly sensitive to the discount rate assumption. The discount rate is the expected rate of return of the plan's assets over the long term. The discount rate will depend on the plan's size, asset allocation, time horizon, and other considerations.

From the City's perspective, the discount rate is important as it is used to determine the City's annual contributions to the plan, the plan's unfunded liability, and the plan's funded status. In other words, the discount rate is used to determine whether a plan has enough assets to meet its future obligations. The discount rate must be realistic to allow the City to foresee funding issues that may impact future operating budgets and future generations of retirees and plan members. If the discount rate assumption is too high and investments earn less than expected, a funding shortfall may result, requiring the City or CalPERS members to make greater contributions than expected.

CalPERS Investment Earnings
Since investment earnings fund nearly 60% of retirement beneﬁts, the City’s pension plan is sensitive to the investment returns of CalPERS. Investment returns aﬀect how much of the retirement beneﬁts can be funded by investment earnings rather than contributions. If investment returns are lower than the discount rate, contributions must increase to make up the diﬀerence. As a result, pension plans need accurate return assumptions to ensure fiscal sustainability.

Currently, CalPERS assumes it will earn investment returns of 6.8% each year. As illustrated in the following chart, over the last 20 years, CalPERS has earned investment returns below the discount rate assumption approximately half of the time. Individual ﬁscal year investment returns have ranged between -24.0% and +21.7%. In particular, CalPERS earned negative investment returns in 2001 and 2002 due to the dot-com crash and 2008 and 2009 due to the Great Recession.

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Note: Beginning in 2002, investment returns are reported as gross of fees.

For FY 2020-21, CalPERS reported an investment return of 21.3%, 14.3 percentage points higher than the 7% discount rate. The average investment return is 10.3% for a 5-year period, 8.5% for a 10-year period, 6.9% for a 20-year period, and 8.4% for a 30-year period. As returns in a given year are volatile, it can be more instructive to look at returns over longer time horizons.

CalPERS Update
Funding Risk Mitigation Policy
Under the Funding Risk Mitigation Policy, the 21.3% return in FY 2020-21 triggered a reduction in the discount rate from 7% to 6.8%. The Funding Risk Mitigation Policy, approved by the CalPERS Board in 2005, lowers the discount rate in years of good investment returns to reduce risk in the portfolio. The Risk Mitigation Policy will affect contributions starting in FY 2023-24.

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Asset Liability Management Process
In November 2021, CalPERS completed its quadrennial Asset Liability Management (ALM) process, which reviewed investment strategies and actuarial assumptions. At the November 15-17, 2021, meetings, the CalPERS Board approved a 6.8% discount rate, selected a new asset allocation for the fund's investment portfolio, and adopted new actuarial assumptions.

During the ALM process, the board examined diﬀerent potential portfolios and their impact on the CalPERS fund. Ultimately, the board selected the portfolio with an assumed investment return of 6.8%.

The new portfolio includes a 5% allocation to leverage.

CalPERS Plan Status
As of the most recent actuarial valuation on June 30, 2020, the City’s pension plan had assets of $103.8 million and liabilities of $157.6 million, resulting in an unfunded liability of $53.8 million and a funded ratio of 65.9%.

The unfunded liability is the diﬀerence between assets and liabilities, while the funded ratio is the ratio of assets to liabilities.

The City has also established a fund, a Section 115 Trust, to reduce pension rate volatility. ANer factoring in the City’s Section 115 Trust, the funded status of the City’s pension fund is 78.0%.

A deﬁned-beneﬁt plan is considered adequately funded if its assets equal or exceed the value of its future liabilities. When the funded ratio is lower than 100%, the plan has insuﬃcient assets to pay all future liabilities.

Poor investment returns during the Great Recession signiﬁcantly decreased the plan’s assets. In addition, enhanced beneﬁts and actuarial assumption changes due to increased life expectancies increased the plan's liabilities. These two factors significantly decreased the funded status of the system.

Over the past few years, CalPERS has taken steps to improve the long-term ﬁnancial sustainability of the system. In December 2016, the CalPERS board voted to reduce the discount rate, also known as the assumed rate of return for investments, from 7.5% to 7.0% over three years from FY 2018-19 to FY 2020-21. In February 2018, the CalPERS board also voted to decrease the amortization period for new pension liabilities from 30 years to 20 years, eﬀective July 1, 2019. While these changes will provide long-term beneﬁts to the pension plan, they will also increase the City’s pension contributions.

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Impact of CalPERS Investment Returns
CalPERS assumes it will earn investment returns of 7% each year. If investment returns are higher than 7%, the City's contributions decrease. On the other hand, if investment returns are lower than 7%, the City's contributions increase.

In FY 2019-20, CalPERS earned 4.7%, 2.3 percentage points below the 7% discount rate. As a result, the City’s required pension contributions will increase to make up for the diﬀerence. The FY 2019-20 investment loss will aﬀect the City’s pension costs starting in FY 2022-23. The contribution increase will be amortized over 20 years and phased in over ﬁve years. In FY 2026-27, when the investment loss is fully phased in, the CIty's annual costs are expected to be $0.30 million higher than previously projected.

For FY 2020-21, CalPERS reported an investment return of 21.3%, 14.3 percentage points above the 7% discount rate. The investment return triggered the Funding Risk Mitigation Policy, lowering the discount rate to 6.8%.

The investment gain and discount rate reduction will impact the City's pension costs starting in FY 2023-24. The discount rate reduction partially oﬀsets the eﬀect of the investment gain. In FY 2027-28, when the investment gain is fully phased in, the City's annual costs are expected to be $1.3 million lower than previously projected.

The FY 2020-21 investment gain will also increase the funded status of the City's plan. As of June 30, 2021, the funded status is projected to be 76% with a 6.8% discount rate.

In 2022, ﬁnancial market volatility has increased due to heightened geopolitical risk, supply chain boWlenecks and persistent inﬂation, and the Federal Reserve’s pivot to a less accommodative monetary policy. Any investment losses will impact the City's future pension costs.

Impact of CalPERS Discount Rate Changes
Due to lower-than-historical interest rates and economic growth, market experts project lower returns for the next several decades. The Pew Research Center forecasts a long-term investment return of 6.5% for typical pension fund portfolios.

During its Asset Management Liability Process, CalPERS considered discount rates between 6.25% and 7%.

Ultimately, CalPERS approved a discount rate of 6.8%, a decrease from the previous discount rate of 7%.

The discount rate has a significant effect on the City's CalPERS contributions. If the discount rate is less than the discount rate assumption, the City's CalPERS contributions will increase. If CalPERS lowers the discount rate by one percentage point, the City's contributions will increase by up to $2.9 million per year.

This analysis shows the potential contribution impact if CalPERS were to lower the discount rate.

Section 115 Trust
A Section 115 Trust is a tax-exempt investment tool that allows local governments to pre-fund pension and retiree health costs. Once contributions are placed into the trust, the City can only use assets from the trust for retirement plan purposes. The City may make withdrawals to either reimburse the City for retirement system contributions or to pay CalPERS directly. The benefits of a Section 115 Trust include the following:

Local control over assets: The City controls the contributions, withdrawals, investment strategy, and risk level of assets in the Trust.

Pension rate stabilization: Assets can be transferred to CalPERS at the City’s discretion to pay for Normal Cost or UAL contributions and can be used to reduce or eliminate large ﬂuctuations in the City’s pension costs.

Potential for higher investment returns than General Fund: Investment requirements applicable to the City’s General Fund assets under Government Code 53601 do not apply to Trust assets.

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Diversification: Trust assets will be diversified from CalPERS investments.

City Strategies
Given that pension obligations are one of the City’s largest ﬁnancial obligations, the City has taken proactive steps to reduce the impact of pension cost volatility. In March 2018, the City provided options to Council to address rising pension costs. In April 2018, the City presented a long-term pension funding strategy to the Fiscal Strategic Plan CommiWee. In May 2018, the City implemented a Pension Rate Stabilization Program (PRSP), also known as a Section 115 Trust, to reduce pension rate volatility on the City’s budget. The Pension Trust helps the City to:

Grow assets for future pension contributions.

Invest assets over appropriate time horizons.

Earn higher investment returns than the General Fund.

Reduce pension contribution volatility.

Diversify funds from CalPERS investments.

As a ﬁscal sustainability measure, the City funds the Section 115 Trust using a more conservative discount rate of 6.25%. The City's pension funding goal is to accumulate suﬃcient funds in the Pension Trust to fund the diﬀerence between a 6.25% and a 7% discount rate and achieve a funded ratio of 80% over 20 years. The City's projections indicated that the City would need to accumulate over $42 million in the Pension Trust within 20 years to achieve its pension funding goal.

To achieve this goal, the funding strategy proposed $8.0 million in initial funding, along with additional funding of $10.0 million over the first five years. The City contributed:
$8 million in FY 2018-19
$4 million in FY 2019-20
$2 million in FY 2020-21
$2 million in FY 2021-22
Total contributions are $16.0 million. As of March 31, 2022, the Section 115 Trust had a balance of $19.5 million and had earned an annualized investment return of 9.35% gross of fees since inception.

Given the funding currently set aside for pension funding, the City is in a solid position to withstand the eﬀects of pension cost increases. If CalPERS earns less than the discount rate assumption, the City will be beWer prepared for future pension cost increases. If CalPERS lowers the discount rate in the future, the City will be better prepared to absorb these costs.

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Fund Balance
The foresight of the City Council and staﬀ in previous years to focus on ensuring healthy reserves is paying oﬀ in full. Increases in sales tax revenues and budget reductions in FY 2020-21 have contributed to this planning strategy and will provide additional resources for the City in the future.

The General Fund’s Unassigned fund balance remains healthy and will be able to assist in addressing funding gaps. In addition, the General Fund's Committed and Restricted fund balance includes:

Economic Uncertainty Reserve ($25 million): may be used to mitigate potential shortfalls in future ﬁscal years.

Capital Projects Reserve ($10 million): may be used to fund capital projects.

Section 115 Pension Trust ($19.5 million): may be used to mitigate potential increases to CalPERS’s annual required contribution rate or further reductions in the discount rate set by CalPERS.

The General Fund’s fund balance is projected to be $97.6 million in FY 2022-23 and increase throughout the forecast. The General Fund's Unassigned fund balance is forecasted to be $35.9 million in FY 2022-23.

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It is anticipated that the City will transfer any unassigned fund balance over the $500,000 threshold to the Capital Reserve, the Capital Projects Reserve, or the Section 115 Trust as described in the City's Fund Balance and Use of One Time Funds Policy.

In FY 2018-19, the City adopted a Section 115 as part of a long-term strategy to improve the ﬁnancial sustainability of the City’s pension system and reduce the eﬀect of pension rate volatility. The City can use funds from the Section 115 Trust to oﬀset unexpected increases in retirement contributions. Funds in the Section 115 Trust are restricted and can only be used to pay CalPERS or reimburse the City for pension contributions.

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Budget-Balancing Strategies
Historically, the City’s budget has been structurally sound, with revenues exceeding expenditures in most years. When revenues have exceeded expenditures, the City has transferred the excess fund balance to the Capital Reserve per the City’s One Time Use and Reserve Policy. The current 5-year and 20-year forecasts anticipate operating deﬁcits near the end of the forecast, beginning in FY 2040-41. The operating deﬁcits are projected to increase as revenues grow at a slower pace than expenditures. As a result, the following strategies may be used to assist in balancing the budget over the next 20 years.

Strategy
Description
Potential Impact
Expenditures

Section 115 Trust
The City established a Section 115 Trust to reduce
pension rate volatility when CalPERS investment
returns are below the discount rate or when CalPERS
changes assumptions.

The City can also use it to offset pension costs in any given year.

The fund is
currently at $19.5
million.*
Capital Projects Reserve
The City has $10 million in its Capital Projects Reserve (General Fund).

The fund is
currently at $10
million.

Economic Uncertainty
Reserve
The City has $25 million in its Economic Uncertainty
Reserve (General Fund).

The fund is
currently at $25
million.
*As of March 31, 2022

Additional Potential Strategies
Although not recommended at this time, the City may consider the following potential strategies in future years if sharp declines in revenues or increases in expenditures cause large structural deficits.

Potential Strategy
Description
Potential Impact
Revenues

Transaction and Use Tax (1/4
cent)
Voter approval is required
Could increase sales tax from 9.125% to 9.375%
$5.2 million
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Transient Occupancy Tax
Measure
Voter approval is required
Could increase transient occupancy tax from 12% to
14%
$1.7M @ $10M base
$1.25M at $7.5M
base
$833k at $5M base
Parcel Tax
Voter approval is required
$3.5M flat rate per
parcel
$3.6M variable rate
per SF
Expenditures

Salary and benefit savings
through attrition
Keep non-essential positions unfilled as they become
vacant.

Approximately
$186,000 per position
on average
Employee cost-sharing of
increases to CalPERS
Negotiate to share costs of increases to CalPERS
employer rates with employees.
$250,000
approximate based
on a 5% rate increase
No new positions
Cost containment strategy
$0
Furloughs
Employees would take up to 20 hours or the equivalent
of a 1% decrease in pay in exchange for 2.5 unpaid
furlough days
$295,000
approximate based
on a 1% decrease
Deferring or eliminating
negotiated increases
The City's current labor agreements expire on June 30,
2022. Deferring or eliminating negotiated increases
would require agreement from the bargaining units.
$295,000
approximate based
on a 1% decrease
Reduction in force
The City would identify what positions could be
reduced (laid off) based on provisions in the MOUs
where appropriate and service level needs in the City.

Approximately
$186,000 per position
on average
Reduction in capital outlays
and special projects
Cost containment strategy
Up to $4 million
Reduction in contingencies
Cost containment strategy
Up to $400,000
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Cupertino City CouncilMay 19, 2022

Cupertino City Council
May 19, 2022