Friday, February 12, 2016

The big question looming over PSPRS reform : What will the expected rate of return be in the future?



They say the devil is the details, so let us look at a detail of the PSPRS reform proposal that may not be getting enough attention.  If you watched the video presentation by the union representatives or read the Reason Foundation Powerpoint, you see a point made about PSPRS’ expected rate of return (ERR).  While most discussion has, understandably, been about specific changes that affect us individually, we would be remiss if we did not point out how the ERR has and will continue to have an outsized effect on all of us.

The ERR is what PSPRS assumes (or expects) it will earn on its investments, and it is sometimes referred to as the assumed rate of return.  There are many factors that actuaries must use to calculate normal costs and unfunded accrued actuarial liabilities, such as wage inflation, mortality rates, membership, and ERR.  Of all these, ERR is probably the easiest for laypeople like us to understand since we can relate to it in our daily lives.  If we go to the ever-useful Bankrate.com and use their savings goal calculator, we can illustrate this quite easily.  If we set a goal of a half million dollars in savings after 25 years at an ERR of 5.0%, compounded monthly, we would have to save about $840 per month for that 25 years.  If we keep everything else the same but change the interest rate to 7.5%, compounded monthly, we would only have to save about $570 per month for 25 years.  Even raising the interest rate 0.25% to 5.25%, would mean that you would drop the monthly savings amount $31 from $840 to $809, which saves $9,300 over 25 years.  If this additional $32 per month was invested at the 5.25% rate, you would have $519,000 saved up instead of $500,000.

So we can see how important the ERR is for the pension.  The lower your ERR, the higher your contributions will have to be, and vice-versa.  Using the same figures from the last paragraph, returning only 5.0% on your savings when your ERR was 7.5% will leave you about $160,000 short of your half million dollar goal because your monthly contribution rate was too low.  You contributed for the 7.5% ERR but earned at the actual rate of 5.0%.  This is PSPRS’ problem.  Employer and employee contribution rates were based for many years on an ERR they failed to actually earn, and like our examples, this produced a shortage.  However, unlike our examples, this is not a saver who just failed to reach a goal.  PSPRS was accruing a liability to its members and had to earn that money.  We also should remember that, not too long ago, PSPRS’ ERR was all the way up to 9.0%.  It has been dropping over the past few years, and currently stands at 7.5%.

PSPRS has changed its investment policy to be more risk-averse, and consequently will be unlikely to earn 7.5%.  The past two fiscal years PSPRS earned 55-60% of the Russell 3000, so in order to earn 7.5% the Russell 3000 would need to earn 12.5-13.6%, which would be very difficult to do over a long period if PSPRS stays with its current investment strategy.  The Russell 3000 would need to earn 8.0-9.33% in order for PSPRS to earn 5.0%, which would still be difficult but much more realistic under the current strategy.

The operating principle that is supposed to be used with ERR’s is that your ERR is supposed to reflect the likelihood of paying off the debt.  If you are buying a junk bond that has a high chance of default, you should expect a high rate of return.  If you are investing for a public pension, which theoretically is an “undiminishable” and “unimpairable” obligation, you should have a rate that is as close to risk-free as possible.  Public pension obligations must be paid under any circumstances, and whatever you invest in should have as close to a guaranteed return as possible.  The risk-free rate has traditionally been the rate on some type of US Treasury bill.

So if PSPRS’ ERR is too high, what should it be?  4%, 5%, 6%?  Regardless, any lowering of the ERR will have major consequences, yet there seems to be no guidance as to what the ERR will be in the future.  When PSPRS dropped its ERR 0.35% from 7.85% to 7.5%, it raised the aggregate employer contribution rate 3%.  What would a decrease of 2.5% do?  This is why it is so important to know what the ERR will be in the near future.  A drop in the ERR will increase the unfunded liability for Tiers 1, 2a, and 2b overnight and will burden employers with even more costs since PSPRS members in these tiers have a fixed contribution rate. 

For Tier 3 members, this will have an even bigger effect on them since they have to split normal costs 50/50 with employers.  If normal costs go up 3%, Tier 3 members will have to pay an additional 1.5% out of their paychecks into PSPRS.  This is why we should all be asking what ERR was used to get the 18% normal cost for Tier 3 members.  In the video presentation, Bryan Jeffries and Will Buvidas gave this as the projected normal cost rate, meaning employees would have to only pay a 9% contribution rate.  If the 7.5% ERR was used, this is an inaccurate rate if PSPRS is planning to move to a lower ERR in the near future, which they almost certainly will have to do since PSPRS cannot earn 7.5% with its current investment strategy.

Furthermore, as we mentioned earlier, lowering the ERR will increase the unfunded liabilities on the other three tiers.  This increased unfunded liability will have to be paid by employers, who will have to find the funds in their already overstretched budgets.  Where do we think these funds will come from?  Even worse for Tier 3 members, this unfunded liability will likely take decades to pay down, so long after most Tier 1 and 2a members are retired, Tier 3 members will still feel the effects of that unfunded liability, a legacy from one generation to another, a gift that will keep on taking.

The only potential good news for Tier 3 members would be an increase in inflation.  PSPRS is a debtor to all its members, and debtors like inflation.  An increase in inflation would mean an increase in the risk-free rate with a corresponding increase in returns on all of PSPRS’ riskier investments.  PSPRS could actually earn more than its ERR without taking on additional risk.  Tier 3 members would see their contribution rates go down as PSPRS earned more and, if their union locals are on the ball, wage increases to keep up with inflation.  PSPRS’ improving finances would also lower its unfunded liability and decrease costs to employers still paying off legacy debt incurred from other tiers.  This would be in addition to a decreased employer contribution rate, which might make employers more amenable to paying raises to their employees.

As we discussed in the last post, retirees will find no benefits in inflation.  They will be stuck with a fixed COLA rate as the dollars they are paid can buy less each year and their standard of living slides.  Raising the COLA will be difficult since it will require another voter referendum to change it.  However, who do you think will be in charge of the firefighter and law enforcement unions then, as retirees go hat in hand to ask them for help.  Hopefully, Tier 3 members will be in a forgiving mood if that day ever comes.

As in so many cases with PSPRS, we see incentives misaligned.  We have retirees competing with active workers competing with people who aren’t even on the job yet.  If an independent board with retiree representation could determine COLA’s on a yearly basis, this might be avoided.  When Inflation reduced the unfunded liability of retired tiers, it could free up funding for higher COLA’s, while still allowing active Tier 3 members to benefit.  Everyone pulling in the same direction for the betterment of all, what a concept!  This almost sounds like something a—what is the word I’m thinking of—oh yeah, a UNION should do.

Thursday, February 11, 2016

Different people, same foolishness: The stupidity of COLA policy comes full circle in the PSPRS reform proposal



Now that the new PSPRS reform plan is out, it might be a good time to look at the numbers, particularly as to how it will affect cost of living allowances (COLA's).  The proposed formula will award of COLA that is the lesser of a regional consumer price index (CPI) or 2% annually.  This will be the rate going forward and will be embedded in the Arizona Constitution.  Retirees will always get some type of COLA as long as there is inflation in the region.  One of the big changes is that the COLA will no longer be based on the average normal service pension, and instead, will be based each retiree's own pension benefit.  This COLA will be funded each year in the normal costs paid by employees and employers.

Since we cannot know what will happen in the future, let us look at past inflation going back to 1999 to see how retirees would have fared if the proposed COLA reform had been in place since 1999.  I used 1999 since PSPRS only has reports going back to 1998.  The inflation figures are as of June of each year.  The chart uses the national CPI, not the regional CPI, though if I were to speculate, I would guess that the regional CPI is lower than the national CPI.  Regardless, here is a comparison of the benefits with actual inflation and the proposed COLA reform:

               Actual         New      Reform        New
Year      Inflation     Benefit     COLA       Benefit
1999       2.00%        $2,432     2.00%        $2,432
2000       3.70%        $2,522     2.00%        $2,480
2001       3.20%        $2,602     2.00%        $2,530
2002       1.10%        $2,631     1.10%        $2,558
2003       2.10%        $2,686     2.00%        $2,609
2004       3.30%        $2,775     2.00%        $2,661
2005       2.50%        $2,844     2.00%        $2,714
2006       4.30%        $2,967     2.00%        $2,769
2007       2.70%        $3,047     2.00%        $2,824
2008       5.00%        $3,199     2.00%        $2,880
2009       -1.40%      $3,154      0.00%        $2,880
2010       1.10%        $3,189     1.10%        $2,912
2011       3.60%        $3,304     2.00%        $2,970
2012       1.70%        $3,360     1.70%        $3,021
2013       1.80%        $3,420     1.80%        $3,075
2014       2.10%        $3,492     2.00%        $3,137
2015       0.10%        $3,496     0.10%        $3,140

Increase                    $1,112                       $756
Average   2.29%                        1.74%

I used a starting monthly benefit of $2,384, which was the average normal retirement benefit at the end of fiscal year (FY) 1999.  As can be seen, using the proposed COLA, a retiree would have been making $3,140/month after 17 years, which is $356 less than the actual cost of inflation.  Over a year this would mean a loss of $4,272, or that some goods that could have been purchased in 1999 would have to be foregone in 2015.  This equates to the retiree having only about 90% of the purchasing power in 2015 that he had in 1999.  Inflation averaged 2.29% over the 17-year period, while the retiree received only an average of 1.74% a year.

I projected the numbers forward for another eight years, which assumes that our hypothetical retiree lives for 25 years after retirement.  This is what we get:
            
              Projected       New       Reform      New
Year       Inflation      Benefit     COLA     Benefit
2016       2.29%         $3,581     2.00%      $3,203
2017       2.29%         $3,668     2.00%      $3,267
2018       2.29%         $3,757     2.00%      $3,332
2019       2.29%         $3,848     2.00%      $3,399
2020       2.29%         $3,942     2.00%      $3,467
2021       2.29%         $4,037     2.00%      $3,536
2022       2.29%         $4,135     2.00%      $3,607
2023       2.29%         $4,190     2.00%      $3,679


After 25 years, the retiree has about 88% of the purchasing power he had in 1999.  For another comparison, this is what retirees actual got between 1999 and 2015 with the excess earnings formula:

1999    $81.95           2008    $134.34
2000    $87.37           2009    $138.66
2001    $93.24           2010    $146.74
2002    $98.17           2011    $152.84
2003    $102.53         2012    $159.13
2004    $111.90         2013    $121.19
2005    $116.82         2014    $65.20
2006    $121.76         2015    $0.00
2007    $127.06         Total     $1,858.90

This total was $747 more than the actual cost of inflation and $1,103 more than what the proposed COLA change would have paid.  Under the excess earnings formula, our retiree would be making $4,243 in 2015 and would be 21% ahead of the inflation.  Since the excess earnings formula used the average normal benefit to calculate the annual PBI, someone making less than that average would be even further ahead of inflation, while someone making more would be less far ahead of inflation.

So the excess earnings formula generally put retirees ahead of inflation, while it appears that the proposed COLA reform will leave them behind inflation.  It becomes clear that there is a disconnect here.  If you watch this video of Professional Fire Fighters of Arizona (PFFA) president Bryan Jeffries, you will see him explain that the PBI formula was put in place in 1985 because retirees were "literally living on food stamps."  I do not know how much of what Mr. Jeffries says in the video is accurate, as he also states that the PFFA was for SB 1609 when the record shows the PFFA was publicly opposed to it.  I do not know what retirees did to keep up with inflation back then, nor do I know if this PBI policy was the same excess earnings formula we have today.  Mr. Jeffries talks as if it was.  However, let's go back and see if we can get some historical perspective.

I used Inflation Calculator to obtain the inflation numbers.  If you are old enough to remember back to 1985, you probably have an idea why they had to do something for retirees then.  I will not use another chart, but if we go back 17 years from 1985, inflation averaged 6.94% over that period of time.  If we used the same $2,384 beginning salary, a retiree would need $7,408 to keep himself even with inflation.  Under the proposed COLA reform, he would have gotten the maximum 2% each year, ending with a monthly benefit of $3,338, $4,070 less than what he needed to keep up with inflation.  This retiree would have only 45% of the purchasing power he had when he began retirement.  Even if he had gotten the maximum 4% allowed under the excess earnings formula, he would only have a monthly benefit of $4,644 and 62% of his original purchasing power.

Inflation was 10.9% in 1979, 14.4% in 1980, 9.6% in 1981, 7.1% in 1982, 2.6% in 1983, and 4.2% in 1984.  I can see why retirees were having to go on food stamps in 1985.  Can you imagine being a newly retired Tier 3 member, living with this type of inflation in the future, who has to watch his purchasing power dwindle away but still having to wait up to seven years before becoming eligible for a COLA?  If you can, you see the problem here.

The policy put in place in 1985 was meant to deal with high inflation.  High inflation generally means that investment returns will increase, even on risk-free investments.  Between the years 1979 to 1984, the yields on 10-year Treasury bills were 9.10%, 10.80%, 12.57%, 14.59%, 10.46%, and 11.67%, respectively, so PSPRS could easily earn its expected rate of return of the safest of investments and much more on riskier investments.  In 1985, retirees would have been legitimately hurting financially and something needed to be done, but policymakers did not understand the problem.  They assumed the problem was that high inflation and corresponding high returns were permanent fixtures, and they designed a bad policy, the excess earnings formula, to deal with it.

Flash forward to today and we see Mr. Jeffries talking about that situation from 1985 as if it were a good-hearted mistake to help impoverished retirees.  What it was was bad policy created by short-sighted people who were either clever/greedy or ignorant/impetuous, or some combination of all of those.  Now we have people with "good intentions" trying to fix PSPRS, but they seem intent on not learning from history and want to put in place another bad policy, albeit with the opposite rationale.

Now we have people who are assuming that inflation will always be low.  How do they know that?  Because their union leaders and politicians, of course.  Let's see what happens to retirees if they are even a little off on their prediction.  If we have 3% average inflation over 17 years, a retiree will lose 15% of purchasing power, 3.5% loses 22% purchasing power, and 4.0% loses 28% purchasing power.  Who believes inflation will be limited to only 2% in the future?  Probably the same people that believed that oil would permanently stay over a $100 a barrel.

The issue here is keeping retirees even with inflation.  This cannot been done with a unchanging, fixed formula that we will function in perpetuity.  The COLA policy for Tier 3 members is especially restrictive and inequitable, and these are the PSPRS members who will have the longest time horizon.  COLA policy should be determined by an independent board with input from all stakeholders, especially retirees, based on the current rate of inflation, funded status of PSPRS, and actuarial projections.  COLA's cannot be set in 2016, when we do not know what inflation will be in 2025, much less the inflation conditions for those retiring in 2042 and beyond.   Worst of all when inflation takes off again in the future like it did in the 1970's and 1980's, there will not be an option to raise COLA's since the maximum 2% will be embedded in the Arizona Constitution.  Do you think Reason Foundation and the Arizona Legislature will be there to help us then?