(In 17th paragraph, corrects to read "costs are passed onto member cities," not "passed onto members," to make clear that the costs are borne by the cities, not by the the employees)
By Tim Reid
April 25 (Reuters) - The City Council of San Jose, in the heart of California's Silicon Valley, wants to quit the state's public pension fund - which covers its current and former members - because it fears it can't afford the rising contributions.
There's just one problem. It also can't afford the "astonishingly high" termination fee of up to $5.7 million that the California Public Employees Retirement System is demanding.
The catch-22 situation comes at a time when cities and states are struggling to manage budgets because of soaring pension costs.
The San Jose City Council voted unanimously in January 2012 to explore terminating its relationship with Calpers, America's biggest pension system with $256 billion in assets. It asked for a termination figure for the 30 current and former council members subscribed to the plan. In January 2013, Calpers pegged the cost at between $5 million and $5.7 million, a figure just made public.
"I was astonished," said Mayor Chuck Reed. "It was a shock." One year ago, he said, the city council's unfunded liability figure estimated by Calpers was about $500,000. "I was expecting at most two or three times that as a termination figure," Reed said.
He said the quit fee was so high that the city, America's 10th biggest with a population of nearly 1 million, had little option but to keep paying into Calpers for the current and former council members. Newly elected members are already offered a different pension plan with lower costs and benefits, and will not pay into Calpers, Reed said. The city's general workforce pays into different pension funds not managed by Calpers.
Brad Pacheco, a Calpers spokesman, said that when a termination fee is paid, cities get fully funded and guaranteed lifetime pension payments for all members in the plan.
San Jose is not the only California city looking for a way out of Calpers or a way to renegotiate their obligations to the system.
The tiny southern California city of Canyon Lake served formal notice to quit Calpers earlier this month, and Pacific Grove, another small city, on the state's central coast, says it wants to quit the plan but cannot because of the high termination fee.
James Spiotto, a municipal bankruptcy specialist and a partner at law firm Chapman and Cutler in Chicago, said the San Jose city council is just a small example of a wider problem in California where cities simply cannot afford their current pension obligations to Calpers. Something has to give, he said.
"If municipalities can't pay, then they have to be able to negotiate" with Calpers, Spiotto said. "You cannot have a situation where a city says they can't do it, but Calpers says they have to do it. That's an impossibility."
Calpers serves many California cities and counties, including the cities of Stockton and San Bernardino, which filed for bankruptcy last year under the pressure of rising costs for wages and pensions.
RATE OF RETURN A BONE OF CONTENTION
Calpers calculated the San Jose council's termination fee based on annual return rates of 2.37 to 2.5 percent -- compared with a the 7.5 percent return rate it uses to calculate future liabilities for members in the plan.
The higher the estimated rate of return, the less an employer has to pay into the plan. But when a pension fund is closed, contributions from cities and workers stop.
"Calpers can no longer go back to employers to make up shortfalls," Pacheco said. "This is why we adopted a much more conservative investment strategy for the terminated agency pool where the assets are moved."
Critics say that Calpers' 7.5 percent long-term projected return rate, as well as similar rate of returns adopted by public pensions across the country, is artificially high. Some economists suggest that pension funds, including Calpers, should be using a lower rate to reflect risk-free investments such as the yields paid by U.S. Treasury bonds.
When a pension fund's returns do not meet its projected rate, a shortfall is created. The costs are generally passed onto member cities. This month Calpers' board approved accounting changes requiring state agencies, cities and counties to pay rate hikes of up to 50 percent to cover the fund's shortfall over 30 years.
Critics say the low discount termination rate produces a huge one-time figure that makes it impossible for cities to quit Calpers, and there is little that a single city can do.
"There has to be a number between 7.5 percent and 2.5 percent, but there is no means for a city to challenge that," said Karol Denniston, a bankruptcy attorney with Schiff Hardin in San Francisco who helped draft California's bankruptcy process law.
In San Jose, the council was worried about its rising monthly contribution costs and a growing unfunded liability to Calpers. Last year the city council paid Calpers $130,700 in annual contributions, and this year it paid over $147,000. Next year's projected annual contribution is nearly $165,000, the city said.
Outside of the council, the city's workforce does not pay into Calpers but into a separately administered municipal plan - similar to other large California cities, including Los Angeles. San Jose's workforce has had significant salary and pension reductions imposed by the city council because of rising city debt.
The council decided to look at terminating its own pension plan with Calpers to show the city's wider workforce that it was interested in reining in elected officials' pension costs. (Reporting by Tim Reid in Los Angeles; Editing by Tiziana Barghini and Leslie Adler)