City leaders rarely talk about service reductions during flush economic times, but that's exactly what's happening in Palo Alto, where the budget outlook is being dampened by a growing and unpredictable pension bill.

The challenge of projecting and addressing the city's pension obligations to its retirees will be one of the first issues that the City Council will tackle in the new year. It is also one that the council's Finance Committee wrestled with on Dec. 5, its final meeting of the year, when it discussed the city's new long-term financial forecast.

The news isn't entirely bleak. Under the default scenario presented by staff, the city will see a revenue shortfall in the General Fund of $2.6 million in Fiscal Year 2019, which will begin on July 1. The forecast assumes that this will be followed by four years of smaller budget gaps, followed by four years of revenue surpluses.

City Manager James Keene told the Finance Committee that he will be presenting a plan to achieve "structural fixes" for the budget gap in the coming months, a task that he said was a high priority.

"Like with anything, the sooner we make structural fixes, the better the future is," Keene said.

But while the projected 2019 gap is relatively modest by Palo Alto's historical standards, things get more precarious further in the future. The city's long-term forecast assumes, in its default scenario, that CalPERS will continue to see a rate of return on investments (or "discount rate") of 7 percent, a rate that the pension fund's own consultant had deemed unrealistic. The consultant, Wilshire Associates, concluded in November 2016 that a more likely discount rate for the coming decade is 6.2 percent.

So far, the pension fund's executive board has chosen not to adopt the 6.2 percent rate, mindful of the fact that doing so would significantly raise the pension obligations of cities throughout the state. It did, however, agree a year ago to lower its assumed discount rate to 7 percent and to phase the change in over three years.

But what would happen if CalPERS chose to go along with the presumably more realistic 6.2 percent rate? According to a new analysis put together by the city's actuary, John Bartel, the change would create a $11.1 million deficit in the city's 2019 budget, followed by deficits of $8.3 million and $6.9 million in the two subsequent years.

For the committee, the new analysis represented a red flag. If the 6.2 percent discount rate is "the real one," Finance Committee Chair Eric Filseth said, the city's budget gap becomes much larger. (Listen to Filseth discuss the city's pension and retiree medical liability he estimates is approaching $1 billion on "Behind the Headlines.")

Even without the potential CalPERS change, the new long-term forecast gave the Finance Committee several causes for concern. It does not, for instance, factor in the growing costs of the city's pending infrastructure projects, which include a new public-safety building, a new bike bridge over U.S. Highway 101 and two new parking garages. Nor does it consider potential new projects, such as an updated animal shelter, the reconstruction of Cubberley Community Center or new athletic fields near the Baylands.

But for the Finance Committee, labor costs were the biggest wildcard. The long-term forecast assumes annual salary increases of 2 percent for city workers. Filseth and Councilman Greg Tanaka both said they were skeptical that the number would be this low and pointed to recent contracts as evidence. Both suggested that the city should plan for larger salary expenses increase down the line.

Filseth, who has made tackling the pension problem a top priority, said the city's assumptions on employee costs will have significant consequences for the public.

"The choices we make, the decisions we arrive at and the accommodations and negotiations we reach with labor groups — these are going to have potential impacts on the community for decades to come," Filseth said.

Tanaka, an avowed fiscal hawk who frequently casts the council's sole dissenting vote on major budget items, challenged staff's assumption that employee costs will stabilize in future years. He cited the city's recent move to bring employee salaries up to market levels, an effort that led to salary increases well above 2 percent for all labor groups.

"We have a hard time holding the line on everything," Tanaka said, referring to the council's history of approving salary raises.

The forecast does, however, include some good news on the revenue front. Tax receipts are steadily rising and Administrative Services Department staff expect to see an increase of 4.2 percent (or $5 million) in 2019, compared to 2018. Budget officials also expect to see revenues go up by about 3 percent in future years, even as they acknowledged the difficulty of making long-term economic predictions.

The City Council plans to discuss the city's financial trends, pension obligations and rising infrastructure costs, on Jan. 22, its first substantive meeting of 2018. The council also plans to meet in a closed session early in the new year to discuss the city's labor challenges and consider negotiation strategies.

Councilwoman Karen Holman, who also sits on the Finance Committee, urged her colleagues and staff to keep these conversations public to the extent possible under bargaining rules. She also stressed the need to be clear and specific in discussing "service reductions." For residents, there is a big difference between saving costs by keeping vacant positions open (as the city had done in response to the 2008 recession) and actually cutting back on services like tree trimming and street sweeping.

"If we just go out and say, 'To fill this gap we're going to need service reductions,' it ain't going to be a happy reception," Holman said.