City Council
Staff Report
From: City Manager
Report Type: ACTION ITEMS
Lead Department: Administrative Services
Meeting Date: January 13, 2025
Report #:2412-3846
TITLE
Review and Accept the FY 2026-FY 2035 Long Range Financial Forecast (LRFF) and FY 2026 Budget Development Guidelines as Recommended by the Finance Committee, CEQA Status – Not a Project
RECOMMENDATION
The Finance Committee and Staff recommend the City Council accept the General Fund Long Range Financial Forecast (LRFF) for Fiscal Year 2026-2035 (Attachment I) and the FY 2026 annual Budget Development Guidelines (Attachment A in Attachment I) and direct staff to use this forecast as the starting point for the initiation of the FY 2026 budget process.
EXECUTIVE SUMMARY
The FY 2026-2035 Long Range Financial Forecast (LRFF) was reviewed with the Finance Committee on December 3, 2024 (Attachment I) along with the annual Budget Development Guidelines (Attachment A in Attachment I) and were unanimously approved by the Committee.
The Base Case Long Range General Fund forecast projects a shortfall of $12.0 million in FY 2026, followed by shortfalls ranging from $7.9 million in FY 2027 down to $5.6 million in FY 2029.
These amounts are fairly consistent with previous projections used as part of the two-year budget balancing strategy when adopting the FY 2025 Budget; however, the FY 2026 shortfall increased by $1 million due to various factors outlined in Attachment I. The proposed multi- year financial strategy addresses the FY 2026 shortfall of $12 million with uncertainty reserves of $6.1 million remaining for FY 2026 budget planning1 and $5.9 million from the FY 2024 Year- end review2. This report summarizes the key discussion points with the Finance Committee and 1 FY 2025 Adopted Operating Budget: Page 10 General Fund Budget Balancing Strategy:
https://www.cityofpaloalto.org/files/assets/public/v/1/administrative-services/city-budgets/fy-2025-city- budget/adopted/palo-alto-adopted-operating-budget-book_final2.pdf 2 December 3, 2024 Finance Committee Meeting, FY 2024 Annual Comprehensive Financial Report (Staff Report 2404-2912): https://portal.laserfiche.com/Portal/DocView.aspx?id=111742&repo=r- 704298fc&searchid=48b115cb-ca8e-4d8c-8fb4-bebeceeb6c24
includes additional information to provide context and/or additional data points of reference to the City Council. Lastly, Budget Development Guidelines inform the development of the FY 2026 budget; these are discussed at the end of the LRFF document (Attachment A in Attachment I).
Per City Council policy, items that are unanimously approved by the Finance Committee are placed as a consent agenda item for the City Council. Though this report was approved unanimously, staff and the Committee have placed this item on the City Council’s action agenda for deliberation of the full Council in acknowledgement of the importance for financial planning in the continued variable economic conditions.
BACKGROUND
The LRFF is a preliminary ten-year forecast based on the most current information available, actual revenues for FY 2024, and projected results through FY 2025 at the point in time of release (December 2024). General Fund expenditures are based on current City Council approved service levels (Base Case) compared to projected revenues over the next ten years.
This Forecast allows staff and City Council to look at both the short-term and long-term financial status of current service levels in the General Fund to inform daily policy decisions and evaluate long-term goals and ongoing challenges. The Committee and staff recommend use of the Base Case for the FY 2026 Budget planning.
•Base Case Long Range General Fund forecast projects a shortfall of $12.0 million in FY 2026, followed by shortfalls ranging from $7.9 million in FY 2027 down to $5.6 million in FY 2029. FY 2030 has a surplus of $2.0 million which continues to grow through FY 2035.
This forecast maintains current service levels approved in FY 2025 and should be used for planning purposes to assist in gauging effects of major policy interventions against a likely “status quo” version of the future. These amounts are fairly consistent with previous projections used as part of the two-year budget balancing strategy when adopting the FY 2025 Budget; however, the FY 2026 shortfall increased by $1 million due to various factors outlined in Attachment I.
•Alternate forecast scenario that reflects a 1% loss in economically sensitive revenue.
Compared to the Base Case, this scenario reduces revenues by $2.3 million in FY 2026 and maintains and increases the projected shortfalls over the next ten years, ranging from $14.3 million in FY 2026 to $0.8 million in FY 2030. FY 2031 begins a surplus of $5.8 million which continues to grow through FY 2035.
•Alternate forecast that reflects a 1% compensation adjustment (1%) in FY 2026.
Compared to the Base Case, this scenario increases expenses by $1.1 million in FY 2026 and maintains and increases projected shortfalls over the next ten years, ranging from $13.1 million in FY 2026 to $6.8 million in FY 2029. FY 2030 begins a surplus of $0.8 million which continues to grow through FY 2035.
These alternate forecasts were calculated with 1% impacts to demonstrate funding levels that could be used to scale the scenarios for larger potential impacts. In addition, these scenarios were calculated separately to show the impacts of each scenario in isolation; however, aspects of both alternate forecasts may occur in conjunction in the future.
Consistent with the projections in the FY 2025 Adopted Budget, this LRFF reflects deficits in the near term with revenues falling below expenses. As previously recommended, the shortfall in FY 2025 will be addressed by the Uncertainty Reserve, that was proactively set aside during the prior year for this purpose. Development of the FY 2026 budget and planning for the subsequent years outlined in the forecast will need to be done strategically over the next several months to balance the increased service level desired by the community with the financial resources currently projected. With these variables, ongoing revenues are unable to keep pace with expenses over the next several years.
The LRFF is a tool to model financial forecasting assuming resources and services are operating at the current authorized levels. City staff will continue to review and refine these projections to establish the FY 2026 budget and use this forecast to begin internal planning for budget balancing solutions. Individual fiscal years will vary from this forecast such as changes in revenue estimates or operating transfers. These circumstances, specific to a given year, typically represent one-time resources that are factored into the annual budget planning process.
ANALYSIS
Finance Committee Review
As part of the Finance Committee’s review of the LRFF, several topics were discussed more in depth and staff has provided additional information for context and/or additional data points for reference to the City Council.
•Revenue categories volatility in the past – The potential national economic conditions and shifting policies cause challenges in forecasting revenues for the upcoming period.
Revenue categories in the city’s budget have demonstrated significant volatility during periods of economic downturn such as the COVID pandemic and Great Recession.
Historical data shows that during the Great Recession of 2008 and 2009, revenue decreases ranged from a sharp -4% in the first year to a more moderate -1% in the second year across certain major tax revenues that are more economic sensitive, particularly sales tax, transient occupancy tax, and documentary transfer tax. This pattern underscores the potential for varying magnitudes of revenue loss depending on the severity and duration of the economic disruption. For context, for FY 2026, a 1% decrease in these more economic sensitive major tax revenues is roughly equivalent to a reduction of $1.7 million of resources for the city. This experience band provides a useful framework for scaling potential revenue impacts, suggesting that while immediate losses can be substantial, the long-term effects may moderate with economic recovery. While staff currently do not forecast a recession, the city remains prepared for the possibility of revenue reductions through fiscal diligence and planning. •Vacancies – For the FY 2026 to 2035 budgetary outlook, one significant assumption is the city's vacancy rate. Our financial forecast currently assumes a 5% vacancy factor, up from the previous 3%, which has tightened the overall budget. The City’s current vacancy rate of 10% reflects a decrease from the pre-COVID level of 12%. Vacancy savings is typically used through alternative expenses such as overtime or contractual services to maintain or manage service levels or allow for flexibility to support Council priority workplans. Public safety vacancy savings is offset with overtime to maintain safety service levels. As of the date of this report, the Police department has zero vacancies and citywide recruitment and retention continue to improve. For context, in FY 2024, the budget assumed vacancy savings of 3%; at the end of FY 2024, net vacancy savings of $2 million translate to just approximately 1% of the salary and benefits expenditures. Setting the vacancy assumption too high could lead to unrealistic target and may result in expenditures exceeding budgeted amount if vacancies are not realized.
•Uncertainty Reserve – The Uncertainty Reserve (UR) was established as part of the FY 2023 Mid-Year Budget Review as a one-time source of funds of $14 million to bridge the funding needed to address community service needs in FY 2024 and FY 2025. The UR differs slightly from the Budget Stabilization Reserve (BSR) in that it can be approved for use with a simple majority vote rather than a 2/3 approval by Council. The UR is also meant to fund short-term budget gaps, while the BSR is meant to be maintained for emergency financial needs and critical budget adjustments needed throughout the fiscal year.
As part of the budget development strategy for the FY 2024 and FY 2025 adopted budgets, the UR was used to fund shortfalls to maintain services and maintain the BSR at 20% in FY 2024 and 18.5% in FY 2025. Adoption of the FY 2025 Budget left $6.1 million in the UR to use for development of the FY 2026 Budget. Staff is recommending increasing the UR to $12.0 million by shifting $5.9 million in surplus savings from FY 2024 from the BSR to the UR. The $12.0 million UR could be used to balance the full $12.0 million shortfall projected in FY 2026 as part of the 2026-2035 LRFF. However, this course of action will eliminate the UR as a strategy to solve the projected $7.9 million gap in FY 2027, unless higher revenues, cost savings and/or other one-time resources are available.
•Risk Mitigation Tools – In addition to the UR discussed above, there are several other tools that staff will explore to reduce the anticipated shortfall in FY 2026 and maintain more fiscal stability in the outer years of the LRFF. These other tools may include:
oInvestigating and recommending updates to existing revenue sources and/or new revenue sources that the City has not collected previously. The City is currently conducting a citywide cost of service study to update its municipal fees and also to identify any revenue sources that are not currently collected.
Depending on the nature of the new revenues, it will take time to conduct the necessary analysis, public outreach and implement the new revenue. oReviewing implementation of policies related to the BSR and funding long term liabilities such as pensions and retiree healthcare, and potentially rebalancing the funding from these priorities to increase funding for current services. The BSR is recommended to be maintained at 18.5% of the General Fund expense budget, but the funding level could be reduced closer to the lower end of the targeted 15 to 20% range. Similarly, the proactive funding for long term liabilities could be reduced in order to fund current services; however, this would prolong the City’s efforts to pay down the costs related to pension and retiree healthcare.
oUsing financing strategies such as Certificate of Participation (COP) to fund costs related to new capital infrastructure projects. These financing strategies could re-allocate funding dedicated to capital needs, such as reducing the base transfer from the General Fund to the Capital Fund and putting those funds towards operating services and maintenance/upkeep of current infrastructure. There would be associated costs for debt administration and longer-term repayment may ensure the City could maintain fiscal sustainability with this strategy. oReviewing service delivery models, approaches and/or innovations to reduce costs or enhance capacity with current resources. While this analysis is performed in each budget development cycle, it will be re-emphasized. •Fiscal discipline – Over the past couple years, the City has been strategically increasing service levels to invest in Council priorities. However, in order to maintain these service levels ongoing as the economy and financial resources stagnate coupled with potential higher uncertainty, continued fiscal discipline will need to be exercised throughout the FY 2026 budget development. Priorities not funded will need to be evaluated against current services to determine if the current services should be augmented with existing and/or additional resources. As stated in the 2026-2035 LRFF report, development of the FY 2026 budget and planning for the subsequent years outlined in the forecast will need to be done strategically over the next several months to balance the increased service level desired by the community with the financial resources currently projected.
The City needs to maintain fiscal discipline and agility while monitoring the upcoming federal policies and their impacts on national and local economies.
FISCAL/RESOURCE IMPACT
Financial implications from this report and input from the City Council will be considered in the City Manager’s development of the Fiscal Year 2026 budget. Upcoming milestones related to the City’s fiscal standing and the FY 2026 Budget Process include:
•February (Council) – FY 2025 Mid-Year Budget Review and Second Quarter Financial Report
•March/April (Finance Committee and Utilities Advisory Commission or UAC) – Five Year Utility Financial Plans and FY 2026 Utility Rate Recommendations •April/May (Finance Committee) – Citywide Cost Allocation Plan and Municipal Fee Study •May (Council) – FY 2026 Proposed Operating and Capital Budgets Published •May (Finance Committee) – FY 2026 Proposed Budget Hearings, including Utility Rates, Municipal Fees, and Five-Year Capital Improvement Plan
•June (Finance Committee) – FY 2025 Third Quarter Financial Report •June (Council) – Adoption of the FY 2026 Operating and Capital Budgets, Utility Rates, and Municipal Fees.
STAKEHOLDER ENGAGEMENT
The preliminary forecast for FY 2026 represents the beginning of the fiscal year 2026 budget development process. As in previous years, City Council discussion of the LRFF will provide guidance to staff in the budget development process. It is anticipated that conversations with City Council and the community will occur through public budget hearings in Spring 2025, according to the standard budget adoption process.
ENVIRONMENTAL REVIEW
This report is not a project for the purposes of the California Environmental Quality Act.
Environmental review is not required.
ATTACHMENTS
Attachment I: FY 2026-2035 Long Range Financial Report (LRFF), CMR 2405-3068 APPROVED BY: Lauren Lai, Administrative Services Director