In 2009, Palo Alto's elected leaders and top management responded to the financial walloping of the Great Recession by embarking on a path toward benefit reform.

Despite a worker protest in front of City Hall, a one-day strike by the city's largest union and a brief legal skirmish, the city succeeded in imposing a new contract on the Service Employees International Union (SEIU), 521, which represents about half the city's workforce. Under the new conditions, union members were forced to chip in for their pensions and health care costs -- expenses for which the city had traditionally picked up the tab. Over the next three years, the city negotiated similar concessions with all other labor groups, with the police union last year becoming the latest to adopt a cost-sharing contract.

Palo Alto's economic fortunes have flipped since then, with vacancies in downtown buildings now below 2 percent and sales-tax revenues rising steadily. But the city's effort to further curb benefits continues. Pension and health care costs are rising at an alarming rate all around the state, recently pushing cities such as Stockton, Vallejo and San Bernardino into bankruptcy. Palo Alto is nowhere near that point, and the city intends to keep it that way, City Manager James Keene said in a recent interview.

"The reality is out there in the world when you look at the bankrupt cities around the state and their inability to pay their bills," Keene said. "We keep coming back to the fact that we're not in that position and we're not anywhere close to it. That's because we keep focusing on how to manage these long-term costs and how we will get more savings or more cost-sharing."

Today, bringing down the city's health care costs is the highest and most contentious financial priority. Though the city has achieved some concessions since 2009, the City Council remains committed to a broader overhaul of benefits for the hundreds of workers who are covered. Some of the changes may start surfacing by the end of this year, when the SEIU's contract expires, and next summer, when the police and fire unions are up for new contracts.

The topic of employee benefits has been recurring since last July, when four council members -- Pat Burt, Karen Holman, Greg Scharff and Greg Schmid -- released a memo sounding alarms about this trend in costs. The council members noted that employee benefits amounted to just 23 percent of salaries in 2002 and to 54 percent in 2010. Today, they account for 63 percent, and in 2022, they are expected to exceed salaries.

The city's benefits, the memo stated, are "reducing the funds available for our community's necessary and valued services and infrastructure." Since then, the city has been holding regular meetings to discuss further reforms, with the most recent one, centered on health care, taking place last month.

The problem is a sizable one even during financial good times. In 2012, the rising cost of benefits largely wiped out any savings the city had hoped to get through staff cuts and the recent employee concessions. According to employee-compensation data that the city released last month, the city's spending on employee benefits jumped by 8 percent between 2011 and 2012, canceling out the city's 3 percent decrease in salary expenditures and leaving the overall spending on employee compensation mostly flat.

While pensions and medical costs both contribute to this trend, it is the latter that will likely take center stage in contract negotiations that will kick off later this year.

With pensions, the city already took giant strides when it negotiated new contracts with more cost sharing by employees and additional tiers with less generous pension formulas for newly hired workers. The measures seem to be working. According to the new salary data, workers chipped in nearly $1 million toward their pensions in 2012, a balance that would have been picked up by the city in years past. In October, Keene suggested that the city has already "maxed out" on the actions it can take to reduce pension costs under the restrictions of the California Public Employees' Retirement System (CalPERS), the mammoth fund that administers Palo Alto's pension and health care programs.

Health care, meanwhile, remains a sore subject for budget officials, a painful one for employees and a puzzling one for the council, which is trying to strike the delicate balance between attracting top talent and keeping costs down. The city's health care costs per employee have risen from $609 in 2004 to $901 in 2009 to $1,080 in 2012, according to the latest Long Range Financial Forecast, an annual snapshot of the city's financial situation. The figures are expected to increase by an even faster rate in 2014, when new mandates from the federal Affordable Care Act kick in, raising premiums for the city by an estimated 9 to 10 percent.

While formal negotiations with the SEIU are yet to kick off, the city's early efforts to launch informal conversations with workers about health care reforms have not gone well. After two informal forums on the subject, employees submitted a letter accusing management of ignoring their concerns. The city, the union leaders claimed, "has clearly pre-engineered" the forums so it can "check the box on employee engagement." The unions also claimed that the city has failed to answer its questions about how the changes will impact long-term workers and retirees.

"All the employee groups question the wisdom and productivity of moving forward with even further changes in benefits when we can't even get a straight answer about the past change and what they mean for long-term employees," the union leaders wrote. "Collectively, we believe it will be difficult for any of us to gain support from our members for new benefit changes unless the inequity in retirement medical that was created by the last round of changes is resolved."

But from management's perspective, health care reform is the only option for keeping the city's finances in order. Last year, the council kicked off a series of meetings aimed at exploring options for reducing benefit costs. With pension reforms already in effect, health care is next. The city is exploring a range of options, including raising the employee portion of the burden and creating new plans that give the city more flexibility in managing costs.

"To really protect the availability of benefits in the future, we're going to have to manage costs better and have better cost-sharing or else the results would be much worse," Keene said in an interview last week. "We can't just pretend that we can continue on this path that has led a lot of cities toward bankruptcy."

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The idea of reforming Palo Alto's health care system isn't new. Fresh ideas resurface every few years and typically involve tense bargaining and incremental progress. The city's last effort, in 2009, resulted in a cost-sharing arrangement for the city and its employees, an agreement under which the city would pay 90 percent of the health care costs and employees (including new retirees) would pay 10 percent (the city had previously footed the entire bill). The contentious reform helped push dozens of midlevel managers and other senior employees to retire to avoid the reduced benefits and prompted a protest and a one-day strike from SEIU, the city's largest union and the first to deal with the benefit concessions. The city ultimately imposed the reduced benefits unilaterally.

These reforms, however controversial, were far less drastic than the ones the city had considered in the more distant past and the one it plans to explore in the near future. For many decades, Palo Alto administered a self-funded health plan that provided retirees (though not their dependents) with medical coverage. According to a recent report from the Human Services Department, this changed in the 1980s, when the cost of providing this coverage shot up by about 50 percent over a three-year period, forcing the city to seek alternatives.

That's when Palo Alto joined dozens of other California cities in signing up for CalPERS, the fund that now provides health care coverage to 1.3 million people. At the time, CalPERS rates were rising by about 6.2 percent annually, a relative bargain, and its 12 different plans looked attractive when compared to the one offered by the city. When the city chose CalPERS in 1993, its driving philosophy was "providing employees with choice and stabilizing cost," the Human Resources report states.

But the switch came at a price. Agencies participating in CalPERS are governed by the Public Employees Medical and Hospital Care Act, which requires agencies to provide contributions to active employees and retirees on an equal basis. Information the city can obtain about its workers' health care needs is far more limited now because costs and risks are aggregated among all participating agencies. And the number of health care plans employees can choose from has shriveled from 12 to six since the city joined.

In recent discussions, council members have frequently voiced concerns about the many limitations that the CalPERS system imposed on the city, with Larry Klein saying that the system in some ways "straight jackets" the city. And Liz Kniss, a leading proponent of wellness programs, bemoaned the fact that CalPERS doesn't provide cities with information on offering incentives for wellness programs. She called these programs "one of the most promising areas in the whole sphere" of health care.

"I'm disappointed that CalPERS doesn't provide that kind of information. This is the kind of thing that makes an enormous difference in employees and in costs over the long run," Kniss said at the council's Feb. 4 discussion of health care reform.

Even so, CalPERS remains the only viable alternative for the city. An attempt by Palo Alto and other cities to start a health care cooperative about five years ago fizzled when costs proved too high. Today, buying insurance on the open market remains cost prohibitive because of the city's large number of expensive retirees. And the city's risk is compounded by the fact that if it leaves CalPERS, it would not be allowed to return to the system for five years.

Faced with these limitations, Palo Alto has spent the last decade baby-stepping toward reform. In 2006, it switched from a five-year vesting schedule for retiree benefits to a 20-year vesting schedule, which gradually increases health care benefits based on tenure (after 20 years, the city would pay 100 percent of the cost).

Recent cost-sharing measures, which now apply to all unions (though the police union is rebuffing the city's attempt to apply it to retirees), have also had some effect. In the current fiscal year, Palo Alto's per-employee cost is expected to actually dip to $1,075 (a decrease of $5 from 2012). But the council and top management all agree that this is not nearly enough. For one thing, medical costs are expected to escalate far faster than the city's revenues, with estimates ranging from 7 percent to 10 percent. For another, more than half of the city's health care recipients are now retirees rather than active workers, which means that they get benefits without making any contributions. And while the number of retirees grows every year, the number of active employees stays largely static, making the situation even worse.

"We're in many ways carrying a whole shadow organization that is significantly larger than our active organization," Keene told the council on Feb. 4, alluding to the retirees.

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The most significant, and controversial, reform proposal currently on the table is one that would scrap the existing "defined benefit" system, which includes six bulky packages from which employees can choose and which keep the benefits steady even in the face of rising costs. Workers and retirees can currently choose to get their health care through one of two HMOs (health-maintenance organizatoins) -- Blue Shield of California and Kaiser -- or four PPOs (preferred provider organizations) -- PERSCare, PERS Choice, PERS Select and the Peace Officers Association of California, which is only available to public-safety members.

What CalPERS lacks, and what the city hopes to offer one day, is a low-cost or high-deductible option for employees who are healthy and would rather not pay for a full-service plan.

This option would be part of what are known as flexible "cafeteria plans," which allow workers to pick the coverage of health care services they need rather than simply choosing a full-service plan. They would also give the city more power to buy only the services its employees need, rather than the ones selected by the CalPERS board of directors. These flexible plans, the thinking goes, would give employees more control over benefits and give the city more control over costs.

The latter point is a particularly poignant one for Human Resources officials. During the detailed Feb. 4 discussion, Chief People Officer Kathryn Shen projected that health care will continue to increase at a rate that is 2 to 5 percent above the inflation level. She called this a "sobering thought."

"From a retiree perspective, you're on a smaller income and your health care costs are going up more than inflation -- that's a problem," Shen said. "It's also a problem for the city because that same inflation-plus plan impacts our ability to provide health care."

Liliana Salazar, senior vice president for compliance for Wells Fargo Insurance Cities, the city's insurance broker, predicted health care costs are expected to rise nationwide by 9 percent on the "lowest end of the scale" and most likely by about 10 percent in 2014, when new mandates from the Affordable Care Act (also known as Obamacare) kick in. Salazar recommended the "flexible plan" as one action the council can adopt to manage these costs. She said many other agencies in California and elsewhere are now working through such changes.

"Most agencies are transitioning from a defined structure to a much more flexible structure,'" Salazar told the council.

The council indicated at the meeting that it supports such a switch and directed staff to consider this option as well as others that "may be considered for negotiation with represented employees and discussion with management employees."

The main barrier for the city is getting employees to buy in, both literally and figuratively. A switch from a defined-benefit plan to a flexible plan would be subject to collective bargaining, and so far, employees have been opposed to seeing their recently reduced benefits pared down further.

While formal negotiations are still months away, the unions have already made their positions clear. Rather than attend the Feb. 4 discussion, as they were scheduled to do, leaders from the main labor unions sat out the meeting, instead submitting letters that voiced frustration and hinted at future litigation. Employees, in a letter signed by most of the major labor groups, charged the city with ignoring their concerns and proceeding with a predetermined and largely unpopular outcome.

Recent efforts by Human Resources officials to discuss the pending changes at forums did little to alleviate these concerns, according to the unions. At two meetings, workers were given a list of benefits and asked to place dots next to those they deem most valuable. Some were allegedly surprised that the issue of "retiree medical," for many the hottest button, wasn't on the list until employees requested it.

Union leaders also claimed that staff "refused to answer questions" about how long-term employees would be affected by the cafeteria plan. The forums, the letter stated, "ended with employees overwhelmingly expressing their desire to protect active and retiree medical benefits and leaving employees with no answers to their questions on retirement medical."

"Based on the outcome of recent prior collaborative efforts and the HR statement of a current desire by a very small number of city staff (in leadership positions) to implement a flexible benefit plan, the employee groups are frustrated by the lack of true engagement and lack of willingness to work with us or answer key questions about our promised benefits long-term employees are already vested in," the letter stated. "Moving forward with a cafeteria-type plan for active employees has the potential to decimate the retirement medical coverage for long-term employees."

Shen and Keene both called the unions' characterization of staff's position unfair. Shen told the Weekly that the city hasn't really started the cafeteria-plan discussion and isn't sure this is the direction in which the city is going.

"No doubt we talked about this as a possibility," Shen said. "But we don't have a cafeteria plan in our back pocket. We absolutely know it's something that would be discussed in bargaining."

Keene said the initial meetings were an "invitation that HR offered to folks to describe some of the challenges we have and to talk about some of the alternatives."

"Nothing in the process is designed in that setting to drive to solution," Keene said.

Unions, for their part, say they remain committed to helping the city save costs and noted in recent correspondence with the Weekly that they are not currently in negotiations and that there are no formal "proposals" from the city at this point. Brian Ward, one of the SEIU leaders, said that all labor groups have joined together and "have proposed cost savings solutions in the past that were not given serious consideration by the city." He also said labor groups have "recently requested to begin discussions with the city on ways to reduce expenditures to preserve city services.

"We have not received a response from the city to date," Ward said.

He also criticized the city's early attempts to introduce health care changes at the two employee meetings.

"Labor groups did not feel this was productive or collaborative, and we have not heard back from the City on the outcome of those meetings," he wrote.

Sgt. Scott Savage, president of the Palo Alto Police Officers Association (PAPOA), said the union has not received any proposals from the city for a cafeteria plan but remains "open to exploring any cost-saving opportunities in the area of employee health care costs."

"The PAPOA has supported proposals in the past that would have resulted in significant short- and long-term health care cost savings to the City," Savage said in an emailed statement on behalf of the union.

City officials maintained on Feb. 4 and in recent interviews that no decisions have been made and that nothing will happen until the two sides meet at the bargaining table. Both Keene and Shen said the unions had mischaracterized the city's early attempts at informal talks about benefit changes. But in a recent interview, Keene made it clear that some change is inevitable.

"We're either going to do some course of looking at greatest cost-sharing -- whether it's 90-10 becoming 80-20 or whatever -- or we can look at something like flexible benefits that give employees more choice and allow cities to focus on how much incremental cost we can provide on our side as a way to manage costs.

"I think flexible benefits will have to be a big part of the discussion but not the only thing," Keene said.

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Palo Alto officials often boast about the progress the city has made toward a balanced budget since 2009, when the Great Recession took a heavy bite out of local tax revenues. But the reforms had one significant unintended effect: They prompted a wave of retirements from some of the city's long-serving employees and put further pressure on the city's already precarious health care picture.

Today, there are 860 retirees and 844 employees enrolled in the city's CalPERS health care plans, according to a recent report from the Human Resources Department. The high number of retirees puts the city in a difficult quandary, driving up costs and making a switch from CalPERS to the open market even less feasible.

"The city's ratio of early retirees to actives is so high that it is a barrier to obtaining coverage quotes from the open market, based on input from insurance representatives," the report states. "Early retirees incur higher health care costs compared to active employees, which insurers specify as a reason to charge higher insurance premiums."

What makes matters worse is that many of these retirees have just left and remain too young to qualify for Medicare, a factor that further ups the city's costs. Of the 860 retired employees, 377 are "early retirees," according to the report. Things are likely to get worse before they get better. According to Shen, about half of the city's workforce is set to retire in the next decade, further expanding what Keene called the city's "shadow organization."

This demographical trend and its grim financial implications pose a particularly tricky challenge for the city council and top management. Councilman Schmid spoke at length about this topic Feb. 4, when he criticized the city's tendency to hire workers who acquire experience in other cities, join the city at 35 or 40, work for a few years and then retire, saddling the city with retirement benefits for many years.

"Why don't we have younger workers -- more younger workers who stay active for longer in the city or go somewhere else to retire?" Schmid asked. "Our financial outlook would be much better."

Schmid observed that as the council proceeded to trim its payroll by cutting positions, it has actually, in a way, made things less efficient. Now, he said, there are fewer active employees who contribute toward health care and more retirees who collect benefits without chipping in.

"So if we meet our efficiencies by cutting employees, we are increasing our per-employee costs," Schmid said. "That's scary."

Palo Alto's legacy of generous medical benefits has helped fuel this trend. According to Kaiser Family Foundation's 2012 Employer Health Benefit Survey, public employers generally contribute more and require their employees to contribute less than their counterparts in the private sector. An average employer contribution in the private sector for covered workers with families is $10,704. In the public sector, it is $12,381.

Workers in the public sector also tend to use plans with higher premiums, according to the survey, with the employer picking up the lion's share. For public employers, the average premium in 2012 was $5,997, with the employee paying $698 and the employer paying the rest (in the private sector, the average premium was $5,297, with workers paying $1,053). It is perhaps significant that up until three years ago, Palo Alto footed the entire medical bill, which made it a particularly attractive destination for new employees.

"Cities that have the most generous retiree medical benefits act as magnets for employees late in their career, whether they're ones coming from other jurisdictions or ones coming from the private sector," Councilman Burt said Feb. 4. "To be able to retire with great medical benefits is a real attraction."

Getting retirees to chip in for health care has proven difficult for management. While most unions agreed, after long negotiations, to apply the 90/10 cost-sharing arrangement to new retirees, the police union has resisted this measure. Last year, when the PAPOA signed a new contract with the city, this issue was left conspicuously unresolved. The city and the union are now going through a process to determine whether the city has the right to reduce medical benefits for police retirees -- a subject on which the two sides have clashed.

Savage said in a statement that when it comes to cost-sharing on health care, the police union believes that "The city is contractually obligated to provide retiree health coverage to those hired before 2006."

"We are currently involved in a fact-finding mediation on this issue," Savage wrote. "We are optimistic that the neutral fact-finding panel will reach the same conclusion."

The union's attorney had a more vehement reaction to the city's recent reform proposals. Peter Hoffmann of the San Francisco-based firm Rains, Lucia, Stern, PC, claimed in a Feb. 1 letter that the city's focus on employee concessions "raises significant legal challenges" and will "likely perpetuate the gross inequity established under the so-called '90/10 plan.'"

The biggest concerns come from the city's longest-serving employees, who have long been banking on having the city fund their health care after retirement. Many are concerned that if active employees accept concessions on health care, these concessions would trickle down to retirees.

Hoffman took issue with a recent report from the city, which states that "a few active employees under the 90/10 plan have expressed concern that in the future, the city benefit may be renegotiated to a lower employer contribution, which would flow to retiree medical as well."

"Contrary to the city manager's suggestion, there are more than 'a few active employees' that have expressed their concerns," Hoffman wrote. "Indeed the number would be much closer to 'all of them' -- particularly among the city's longest-tenured employees who stand to see their promised retirement benefits eliminated, just as they approach the end of their careers."

Hoffman called the report "little more than a feeble attempt to begin preparing for the anticipated legal challenge."

Management has disputed the union's claims about predetermined outcomes and insufficient engagement. At the Feb. 4 meeting, Keene was adamant about the fact that no decisions have been made and that staff has been approaching the unions in good faith and with the understanding that any deals would have to be made through the bargaining process. But he also said that the city is committed to having more cost-sharing between the city and its employees -- both active and retired.

The drama will play out at the bargaining table in 2013 and 2014. While council members have encouraged staff to hold forums and conduct more outreach in hopes of easing the pain for employees, staff acknowledged at a recent discussion that when it comes to health care concessions, there really is no easy way to have a conversation.

"I think the difficulty is going to be that consideration of greater contributions by employees, or sacrifices, are difficult conversations for people to have," Keene said Feb. 4. "To sort of say, 'I like that meeting. Let's do that again' -- it's not that pleasant."

See full-size images of the story's accompanying graphics:

City of Palo Alto health care expense.

Percentage of firms offering retiree health benefits.

What percentage workers pay of their premiums.