Palo Alto took a giant step on its road toward reducing employee costs Tuesday night, when it approved a contract that forces about 200 managers to contribute more toward their pension and health care expenses.

But even as the City Council approved the agreement, members vowed to pursue in the coming months further reforms geared at curtailing the spiking benefit costs.

The new contract with the non-unionized group of managers and professionals achieves concessions similar to those the city recently agreed to with its largest police union, its firefighters unions and with the Service Employees International Union, Local, 521, which represents more than 600 workers, about half the city's workforce. It will require managers and professionals to contribute significantly more toward their pension and health care expenses -- costs that have traditionally been borne by the city.

On pensions, the management group will now be required to pay the maximum "employee contribution" toward the California Employment Retirement System (CalPERS), the giant fund that administers the city's pension benefits. The employee contribution is either 7 percent or 8 percent of the city's total pension obligation, depending on each employee's pension plan. This would be a major increase from the 2 percent they currently pay.

The 202 managers and professionals will also have to pay extra for medical care under the new contract, which the council enthusiastically approved Tuesday night with an 8-0 vote (Sid Espinosa was absent). While the city has historically footed the entire health care bill, managers and professionals will now be required to contribute 10 percent of the cost. This change is expected to save the city about $109,000 annually, according to a report from Sandra Blanch, assistant director of the Human Services Department.

In exchange for the concessions, the city has agreed to give this group a 3 percent salary increase. Even with this pay bump, the average paycheck will drop by 4 percent because of the increased contributions, said Kathryn Shen, director of Human Services.

"We know this is painful," Councilwoman Nancy Shepherd said toward the end of the discussion. "It's painful for the council, and I really appreciate the management group for making these changes so that we can bring ourselves back into sustainability."

Much of the conversation centered on the city's response to a recent report from the Santa Clara County Grand Jury, which analyzed the unfunded liabilities of each city in the county and concluded that existing obligations are unsustainable. The report recommended a series of pension reforms, including a second pension tier (with a less generous pension formula) for new employees, increased "employee contributions" toward pensions and increasing the retirement age -- changes that the city has been gradually adopting since 2008.

The council generally agreed with the report's conclusions and recommendations, even as members acknowledged that their power to implement pension reforms is limited by state law. Several major Grand Jury recommendations, including a switch from "defined benefit" plans (in which a retiree is guaranteed constant and predetermined pension payments) to "defined contribution" plans (in which pensions payments fluctuate based on performance of CalPERS investments), cannot be legally implemented without legislative assistance. Councilwoman Karen Holman pointed to these legal barriers as a major reason why the city can't make the types of sweeping changes residents call for but said the council is "doing the best we can."

The council approved the contract with the managers group after a long, broad and extensive discussion about the Grand Jury report and pension reform in general. The topic that will return to the spotlight on Sept. 18, when members consider further reforms. The meeting was prompted by a colleagues memo from Vice Mayor Greg Scharff and Council members Pat Burt, Holman and Greg Schmid. In the July memo, the council quartet pointed to the swelling employee benefits (which comprised 23 percent of salaries in 2002 but increased to 54 percent of salaries in 2010). The memo urged the council to "provide policy direction regarding future reforms and innovation in employee benefits, pensions, compensation and other aspects of employment."

Councilman Larry Klein said Tuesday that among the policies the city should consider at the hearing is whether the city should continue to provide medical coverage to employees' families. He noted that Palo Alto is one of the few cities in the area that has such a policy.

Other reforms that the council could consider is moving toward fixed health-benefit contributions, providing more employee choice in health benefits and encouraging changes in state law that would allow Palo Alto to establish a pension plan combining defined benefits, defined contributions and Social Security.

Chief Financial Officer Lalo Perez said that while the city continues to face a major challenge in curbing the cost of employee benefits, much progress has already been made.

"I think we're being progressive in Palo Alto. We're being leaders," Perez said.

The city still faces major challenges when it comes to unfunded liabilities, he said, but it's not standing still.

"We recognize it and we're taking action," Perez said.

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