Cottonwood – A Small Arizona City
at the Turning Point

By Sherry Twamley, Editor and Publisher, Verde Village News 
(November 4, 2018)

The purpose of this editorial is to provide an overview of the multiple financial crises that are about to drown Cottonwood taxpayers.   Regardless of one’s ideology, it’s not hard to see that a problem exists. The city has more IOUs than available funds or projected returns to pay the IOUs.   There are only TWO (2) WAYS to fix the City’s distressed finances/weak cash flow, namely; 1) Cut the bottom line (expenses)  2) Or grow the top line (the economy) to boost income/revenues.  The problem is simple:  the City of Cottonwood continues to spend more than it takes in without raising taxes for inflated personnel costs.

Let’s face it.  Cottonwood officials set out to become a metropolis that could compete with Phoenix and much bigger cities, by building an airport, a $40 million Recreation Center, its own police and fire departments, a regional 911 safety communications center, a library, water and wastewater utilities, and now under construction – the estimated $14+ million vanity mega-project Riverfront wastewater reclamation plant on the banks of the Verde River.  In fact, some research suggests there’s a tipping point when it comes to these measures. The more services a city needs to provide, the more tax revenue it must raise from residents.

A few of the biggest risk factors are lack of reserves, anemic economic growth, sales tax dependency and revenue volatility (Cottonwood has no property tax and is solely dependent on tourism), millions in taxpayer debts and unfunded pension liabilities, decreases in state highway and other funds, increased personnel costs and spending, the economy and people (demographics and spendable income) and lack of fiscal discipline and debt policy. 

Years of expanding government services, lack of fiscal restraint and mismanagement, and incompetence by its hyper progressive City Council have taken its toll. Former Cottonwood Mayor, city councilmembers and City Council-Appointed City Manager, controlled the political reins for more than 13 years, while incompetent and complacent council members including present Mayor still continue to deny and ignore the city’s fiscal threats including the rising unfunded pension debts and spiking personnel costs.

For more than a decade, elected and appointed Cottonwood city leaders implemented unsound fiscal policies resulting in millions of dollars in unfunded pensions, a high debt-to-income ratio, phenomenal personnel cost and pension growth, hyper investment in seven city services by issuing taxpayers’ debts, four annexations and six private water company purchases.  

The City failed to set aside payments for its retiree benefit obligations and in FY 2017, was in arrears by $25.3 million in unfunded pension liabilities.  Unfortunately, it will likely take years for Cottonwood to right the ship of government as it carries far more debt per capita than most other small cities in Arizona. Unfortunately, there are no overnight fixes for the years of fiscal mismanagement and lack of restraint.

The tumult of the former Mayor administration began when the public elected her in 2003. It started at the top when citizens elected a Mayor who has little to no management experience, no financial experience, no business experience, no technical experience, and no formal academic credentials.  A candidate such as a salon owner, housewife, farmer or administrative assistant is not qualified to run a city. Even worse, and crony council members handed Cottonwood Police Chief the city manager job without a proper selection process, knowing that he was formerly a fired police chief of the City of Scottsdale and had no city management experience.

What the Mayor and council members lacked as City managers, seemed to more than make it up as figureheads. The mayor took bows and credit for a number of positive developments, including Old Towns rebound.  But that has been Cottonwood’s outside face for more than a decade.  Inside, fiscal pandemonium is evident.  The city’s deeply-entrenched financial problems go back to the acquisition of three private water companies in October 2004, and the subsequent purchase of three additional private water companies. 

Cottonwood is certainly begging, even if they do not know it, for an adult to step forward and tell it “no” for a change. 

The City has already leveraged all of its sources of income to repay/guarantee bond debt repayments and balance the budget.  For example, the City’s main source of income — its excise taxes (sales and utility taxes) — driven  primarily by outside residents and tourists,  were recklessly used to guarantee three bond debt repayments — which may present the biggest risk to the City’s ability to sustain itself in future years without imposing a property tax or a sales tax increase.  The City also issued three long-term debts guaranteed by its City Water Utility’s bills payments. When there is a downturn in the economy, tourism will drop, and so does the main source of the City’s income because the city has no property tax, cash reserves are low and the city is highly indebted.  But the City has exhausted all of its credit lines.

A bigger question is whether the city can make needed, permanent fiscal reforms to put the City’s finances in order.  For the past decade the city experienced hyper growth in city services, infrastructure, personnel and pension growth.  The critical question is: how will the city get its financial house back in order, build a sound financial structure to fund the delivery of services residents and businesses need without continuing to push the cost of government expansion and debt onto future generations?  A new city manager should make it a priority to get the City’s “financial house in order,” starting with the pension systems.   

In 2018, the City of Cottonwood created three new tax increases that included a .5 percent sales tax increase, a newly levied use tax, and new water and wastewater impact connection fees that will push the cost of new homes up in Cottonwood by thousands of dollars.  Together, the rises in City tax rates will eventually decrease the amount of revenue because residents are free to move to a location where their demand for services matches the taxes they must pay, and historical show how even a dollar increase in local taxes harms economic growth.

Professor Robert Inman of the Wharton School at the University of Pennsylvania Inman’s sound fiscal policy framework for cities starts with deciding what services to provide and which ones not to provide.  Cottonwood has a library, an airport, a regional communications center, a recreation center which lost $1.7 million in FY 2017, city police and fire departments, a water and wastewater utility, and an estimated $14 million satellite Riverfront wastewater reclamation plant still under construction boasting a learning center (now a meeting room), solar panels, state of the art technology, and a 6 foot wall around it on the banks of the Verde River in a 100-year and 500-year flood plain. 

If the proportion of a city’s residents who are either elderly or living in poverty gets high enough, it could cause middle-class residents to move away.  Robert Inman, a University of Pennsylvania professor, explored how “bad” demographics act as a risk factor for cities. He’s devised a figure — 35 percent of a city’s population being either elderly or living in poverty — that, if exceeded, could signal significant fiscal problems. It’s based on the assumption that at this level, middle-income residents will pay roughly 20 percent higher taxes for the same services as they would in nearby jurisdictions, leading them to consider moving out of the city.  In fact, some research suggests there’s a tipping point when it comes to these measures. The more services a city needs to provide, the more tax revenue it must raise from residents. If the proportion of a city’s residents who are either elderly or living in poverty gets high enough, it could cause middle-class residents to move away.

The huge gap between city managers’ salaries and benefit packages and citizens’ pay, and its pension gap grows wider every year, even though the financial markets in other Arizona cities have rebounded much faster than Cottonwood’s economic growth since the end of the recession. That’s because Cottonwood’s pension bills keep piling up, public employees automatically receive annual pay raises, and plans fall further behind on optimistic pension funding assumptions.  We must take the initiative to consider pension reform before the problem becomes all-consuming and leaves us with two awful options: break promises to city retirees or take income from our children and grandchildren. 

 Is Cottonwood’s $25.3 million pension liability a ticking time bomb?

Under new rules, reporting on pensions is more closely tied to general accounting standards, rather than to plans’ individual funding policies.  New accounting standards spotlight poorly funded plans. Public pension systems are a ticking time bomb for All Americans, not just Cottonwood’s residents.  Throughout the country, virtually every state and almost every city is facing a similar dilemma of how to deal with massive pension shortages.  The soundness of many state and local pension and retiree healthcare plans are of grave concern. Nationwide, unfunded liabilities for state and local pensions and retiree health care range from $1.4 trillion to over $4 trillion, depending on what assumptions one uses. Presently, most public pension plans guarantee retirees a set income for the rest of their lives. Taxpayers could be left holding the bag either through reduced services or higher taxes now and in the future as borrowing costs rise and the financial holes in the pension systems are filled.

The city’s fiscal constraints will make it both tougher and more urgent to find affordable ways to keep their retirement commitments to their workers Many retired Cottonwood public servants could soon be asking the question, “Where’s my money”?

Local pension problems can also trickle up. Whether a city was fiscally disciplined made a big difference in how it fared. Cities with pension plans that kept up with their payments—consistently making the “annual recommended contribution” calculated by their actuaries—weathered the financial downturn better than their counterparts.

Many cities have begun to make reforms, such as trimming the benefits they offer and raising workers’ retirement age, increasing employees’ contributions, or reexamining their use of traditional “defined benefit” pension plans that guarantee income for life, among other actions.  

Cities can avoid these potentially devastating problems by moving away from pension (defined benefit) retirement benefits and toward 401(k)-style (defined contribution) retirement benefits. Taxpayers would only be liable for one-time, per-pay-period contributions to employees’ personal retirement accounts. Employees would have control over their accounts, which would be their exclusive property. In San Diego, a proposition to move public employees into defined contribution retirement benefit programs won overwhelming voter approval with 66 percent of the vote. In San Jose, California, major changes to the pension program to lower its costs passed by proposition with 69 percent of voters approving of the change. The benefits of such changes will take a long time to come to fruition, but they are worthwhile in order to secure the long-term financial viability of cities.

The government could either break its promise because it could not afford to pay all pension members, or the government could take money from our children and grandchildren to pay pension holders through higher taxes. Many people find neither option attractive.  For example, Texas public pension holders faced a serious problem–the made promises they were unable to keep and will have difficulty paying them off. The fact that their pension plan recipients outnumbered pension plan contributors meant more money went out than came in, drying up the pension well. As the base of the pyramid shrank, fewer lines of funds flowed to the top. Eventually, the top became larger than the bottom and the whole thing collapsed. One would expect this to happen with bad scams, not retirement plans that workers spent years paying into.  This is a risk to every government.

After years of not setting aside enough money, state pension funds are looking at a $1 trillion shortfall in fiscal 2017 — the last fiscal year with full results — of what they owe workers in benefits, according to analysis from The Pew Charitable Trusts. Heavily burdened cities such as the City of Cottonwood may be facing a similar threat – the City has a $25.3 million unfunded pension liability, dwindling reserves, and a significant debt load.

The Growing Funding Gap for City Pensions Puts City Residents at Risk

Many City taxpayers may be unaware of the magnitude of the City’ pension gap on the City’s finances as it is not prominently posted on the government website. This is important because the City’s unfunded pension liability could be its greatest financial threat.  Arizona’s constitutional provisions effectively declare pension benefits sacrosanct and prioritize pensions over every other type of spending.  What will happen when the City can no longer pay its retirees?

The City’s finances may now be at the tipping point.  The biggest pension gap is the City’s first responders – police and fire department personnel.  The city has been shortchanging their employee pension funds and aren’t adding enough money in emergency funding accounts to prepare for the next economic crisis or recession.

How are ‘bad’ demographics a big risk to Cottonwood?

High poverty rates, high unemployment and older populations can stretch a city’s services thin. While state and federal programs provide a lot of support, localities inevitably are burdened with additional costs.  Economically depressed cities like Cottonwood and a few college towns, are characterized by exceptionally steep demographic hurdles with high percentages of elderly and poor population. By contrast, the elderly and poor make up less than a tenth of the population in many other jurisdictions reviewed.  Generally speaking, if a city has a high number of elderly and poor residents who consume more public resources than they contribute to the tax base, there will more likely be potential problems for that city’s fiscal outlook.

Robert Inman, a University of Pennsylvania professor, has conducted research exploring how “bad” demographics act as a risk factor for cities. He’s devised a figure — 35 percent of a city’s population being either elderly or living in poverty — that, if exceeded, could signal significant fiscal problems. It’s based on the assumption that at this level, middle-income residents will pay roughly 20 percent higher taxes for the same services as they would in nearby jurisdictions, leading them to consider moving out of the city.

“Cities are going to feel this kind of demographic pressure on their budgets,” said Inman. “But good economies and good policies can overcome the demographic disadvantage.”

In Flint, Mich., the latest Census estimates suggest that people either living in poverty or age 75 and up account for a staggering 45 percent of the total population — the highest share in the country. Estimates for Detroit and Cleveland aren’t too far behind.

Of the nation’s 500 largest localities, 22 exceeded the 35-percent population threshold in 2015. Nationally, about 20 percent of Americans were living in poverty or at least 75 years old. The two competing ways of valuing a pension fund are often called the actuarial approach (which is geared toward helping employers plan stable annual budgets, as opposed to measuring assets and liabilities), and the market approach, which reflects more hard-nosed math.  The market-based numbers are “close to the truth of the liability,” Professor Sharpe said. But most elected officials want the smaller numbers, and actuaries provide what their clients want. “Somebody just should have stopped this whole charade,” he said.  The problem reaches far beyond pensions, and into the $3.7 trillion municipal bond market. The reason is that municipal bond ratings take into account the strength (or weakness) of government pension plans. If those numbers have been consistently wrong, as dissidents argued, then actuaries were helping mislead the investors buying municipal bonds.

The market value of a pension reflects the full cost today of providing a steady, guaranteed income for life — and it’s large. Alarmingly large, in fact. This is one reason most states and cities don’t let the market numbers see the light of day.

But more important, it raises serious concerns that governments nationwide who are low on pension transparency and low on paying off pension debt, do not know the true condition of the pension funds they are responsible for. That exposes millions of people, including retired public workers, local taxpayers and municipal bond buyers — who are often retirees themselves — to risks they have no way of knowing about. 

“One of the first things I think you should do is publish the pension numbers for every city,” said William F. Sharpe, professor emeritus of finance at Stanford University’s Graduate School of Business who won the Nobel in economic science in 1990 for his work on how the markets price financial instruments.

Today the city of Cottonwood continues to hire employees, provide employees with zero co-pay health benefits, award annual pay raises and proportionate benefit increases.  So the oncoming wave of public pension debt in Cottonwood is far bigger than it seems as the gap between money available and promises the city makes continues to grow (According to a 2013 report by Morningstar, an independent financial research group, most pension plans continue to be funded below the 80 percent level considered necessary for a healthy fund).  

Higher pension costs can have the following consequences:

• higher taxes
• less intergovernmental aid for services
• lower credit ratings
• higher interest rates on state borrowing

Not everyone is confident the newcomers will be able to solve the problems.  There are a lot of people who felt frustrated and saw right through the empty boasts, including Yavapai County Supervisor, Randy Garrison and the late, former City Councilmember, Darold Smith. In no city department does there appear to anyone who is good at turning things around or providing dependable information without a political ‘spin’. Positive news from the administration should always be checked by the public and the media, but even the negative news should be checked too–that way, there is some fairness in the reporting, and we can rely on what we read.

Turnaround plans must include regular financial monitoring and big picture financial monitoring and big picture financial reviews beyond audits, on a monthly basis, and pension transparency.

Any of these issues on their own would be difficult for a city to deal with, but together the fiscal distress could precipitate a fiscal catastrophe.