Driven by increasingly higher pension and benefit costs, employee compensation now makes up 63 percent of Palo Alto's General Fund budget, an unsustainable situation that could cripple the city in the years ahead.

But as the Weekly's cover story last week described, it will not be easy to reduce these pension obligations and the potential big impacts on all other parts of the city's budget.

The proportion of dollars paid for employee benefits to salaries is up from 23 percent in 2002 to 54 percent in 2010 and will be 63 percent by fiscal year 2012. Employee benefits alone now comprise 27 percent of the general fund budget.

This snowballing crisis is not unique to Palo Alto, or even small cities. Earlier this week a federal task force found that many states, including California, are facing higher health care costs and underfunded pensions while revenues are sliding backward. Many have resorted to budget gimmicks and borrowing to make ends meet. And some cities, including Stockton and San Bernardino, are opting for bankruptcy as a solution.

In Palo Alto, the pension problem has been growing for years, but high investment returns lulled most municipalities into a false sense of comfort.

For example, in 2007 the city made a deal with the Service Employees International Union to trade a less generous health care plan for a bump in the pension formula that raised the pension benefit from $60,000 to $81,000 a year for an employee retiring with $100,000 a year in income after 30 years of service.

It is deals like this that will push the cost of 2013 pensions to $23.1 million, up from just $3.8 million in 2002 and $2.4 million in 2003. Health care expenses are expected to reach $24 million this fiscal year and to be near $30 million in two more years, three times the $10 million cost in 2002.

A major part of the problem is the lackluster investment performance of CalPERS, the state retirement system, whose most recent report showed a meager 1 percent return, a fraction of its 7.5 percent goal. When CalPERS earnings fall, cities are on the hook to make up the difference in retiree paychecks. This is a double whammy for Palo Alto, which already pays a large part of employee retirement contributions to CalPERS.

And the city's costs are spiraling upward for another reason: the higher salaries earned by top city employees that follow them out the door when they retire. For example, former Police Chief Lynn Johnson retired after more than 30 years in 2009 with an annual pension of $201,953, and former City Manager Frank Benest isn't far behind with $193,351. Eighty-eight of the city's 954 retirees receive more than $100,000 a year, which does not include the cost of health care benefits for themselves and their family.

The city is making slow progress toward rolling back this trend by negotiating two-tier, less costly retirement packages with most unions that offer new employees fewer benefits than current rank-and-file workers. And the city is asking workers to pay more of their employee contribution to CalPERS. At a meeting in May when the council was discussing the long-range financial forecast, Vice Mayor Greg Scharff said that medical and pension costs are "running at an unsustainable rate and crowding out everything else."

"What we're asking people to do is accept a lower quality of life so that we can fund pensions and benefits that are growing at an outrageous pace. I don't accept that that should be the plan."

Scharff hopes a September city council discussion on pensions will get to the legal aspects governing the rights of employees and the city in pension matters. For example, could the city roll back a pension set at 2.0 at 55 to a 2.7 at 55 plan midway through a worker's career? This is a legal issue that has not been tested, Scharff said. The city is also handcuffed by restrictions put in place by CalPERS, which does not allow 401k-type plans and sets stiff penalties if the city wants to withdraw from the system, he said.

Voters would probably be ready to support efforts to roll back some of the city's pension commitments, similar to the decision to throw out binding arbitration for fire and police contracts, which was a major step for the city.

But at this time, it is not clear what options the city has to gain control of its pension costs, which are expected to grow faster than revenues in the years ahead. According to a Santa Clara County Civil Grand Jury report, the city's current pension liabilities are $153.9 million and its health care liabilities are $105 million, or $259 million in all. The total gives Palo Alto the dubious distinction of having the highest debt per resident in the county, at $4,021.

Clearly identifying its options and their legal risks needs to be a top priority for the city in the months ahead. In all likelihood, changes in both state law and city policy will be needed, since the progress being made in negotiating new labor contracts only slows down the growth of the problem. We look forward to a robust council discussion on the subject in September.