Wednesday, April 29, 2015

Belling the PSPRS cat: a fable brought to you by the League of Arizona Cities and Towns PSPRS Pension Task Force

Back in February, I attended one of the PSPRS employer seminars.  It was among one of several that PSPRS and the League of Arizona Cities and Towns PSPRS Pension Task Force ("the Task Force') put on in different locations throughout the state.  The handouts from these seminars are available here at the Task Force website.

The seminar was broken into two parts, the first part presented by PSPRS and the second by the Task Force.  The PSPRS was handled mostly by PSPRS' Acting Administrator Jared Smout and covered a broad range of topics, ranging from general discussions about pensions and PSPRS to more specific discussions about the causes of PSPRS' underfunding, COLA's, and the lawsuits challenging SB 1609.  I was interested in two particular issues when it came to the PSPRS presentation.  The first was what is the status of Hall v. EORP (CV2011-021234), which is challenging the SB 1609 changes to the COLA formulation for EORP members who were still active when SB 1609 became law and the increase in employee contribution rates.  The successful Fields decision only challenged the change in the COLA formulation, as the plaintiffs in that case were already retired.  There is a shadow case against PSPRS, Parker v. PSPRS, that is challenging PSPRS on the same grounds as Hall.  The decision in the Hall case will settle both cases, so it has great relevance to any PSPRS member who was active when SB 1609 went into effect.

Unfortunately, the case still remains in the courts and the latest information shows it is under appeal.  This case will have to be settled by the Arizona Supreme Court, so we are still stuck in a holding pattern.  My amateur interpretation and prediction from an analysis of the Fields decision is that the plaintiffs will win on the question of COLA's but lose on the question of employee contribution increases.  The COLA question is a slam dunk for the plaintiffs and was already addressed in Fields.  COLA's were deemed a pension benefit and could not be changed per the Pension Protection Clause of the Arizona Constitution.  The question of employee contribution rates will depend on how the Arizona Supreme Court interprets the Contracts Clause in the state and federal Constitutions.  The Fields decision did not consider the Contracts Clause, but a reading of the decision shows that the question of employee contribution rates has no clear precedence and may not be covered under the Pension Protection Clause.  We will all have to wait and see how the justices rule.

The second issue I was hoping the PSPRS presentation would deal with was simpler: what a victory by the Hall plaintiffs would cost PSPRS.  According to PSPRS' esitmates, a plaintiff victory would cost PSPRS $931 million and drop PSPRS' aggregate funding ratio 4% and raise its aggregate contribution rate 6%.  He did not break down what would happen if the plaintiffs only won on just one of their questions, so this appears to be the cost of a total victory by the plaintiffs.  Remember that if the plaintiffs succeed on the question of employee contribution rates, anyone active at the time SB 1609 went into effect will be owed a refund of all contributions they paid in excess of 7.65%.  For the current fiscal year alone, that would 3.4% of pensionable income.  This would be a significant refund due of $2,040 for someone who had $60,000 in pensionable income in the current fiscal year.

I was more interested in what the Task Force had to say.  This portion was conducted by members of the Task Force, including former Tucson Chief Financial Officer and Deputy City Manager Kelly Gottschalk, who has since been hired to run the Dallas Police and Fire Pension System.  To say that their presentation, and particularly their recommendations to cities and towns dealing with pension costs, was a disappointment would be a huge understatement.

The Task Force was set up in June 2014 and made up of 15 members, mostly high-ranking municipal finance and administrative officials from throughout Arizona.  Last summer and fall, they had several meetings where they received presentations from various stakeholder groups and others with pension expertise.  There is a wealth of information on the Task Force website, and I was encouraged that finally something worthwhile was being done regarding PSPRS.  I thought that those municipal officials dealing with the harsh consequences of PSPRS' financial woes would finally have a chance to come together, brainstorm, and come up with some great reform ideas to present to the Arizona Legislature.  Boy, was I wrong.

Following are the Task Force's seven recommended practices for employers:
  1. Budget contributions for DROP members
  2. Prepay your budget contributions
  3. Do not defer the Fields case
  4. Review local board practices
  5. Prepare a comprehensive study
  6. Pay off unfunded liability (debt) earlier
  7. Create a pension funding policy
If we eliminate the three practices (numbers 4, 5, and 7) that are essentially administrative tasks, the other four come down to telling employers to pay more.  Of all the recommended practices, the first is the most ridiculous of all.  Recommended practice number 1 tells employers to budget for and continue to pay contributions for members who have entered the Deferred Retirement Option Plan (DROP).  However, the DROP was supposed to be a "win-win" for employees and employers where experienced employees remained on the job but neither employees nor employers would have to pay pension contributions for up to five years while the employee was in the DROP.  The Task Force is now saying that employers should continue to pay pension contribution for employees once they enter the DROP, meaning the employer gets no financial benefit from the DROP.  The most logical recommendation would have been to advocate for the complete elimination of the DROP, a program that has been starving PSPRS of funding for 15 years and will continue to do so as long as it remains active.

Recommended practices numbers 2, 3, and 6 all advise employers to pay money they do not have.  I agree with recommendation number 3 because it sets a bad precedent in a state where employers have always paid their full, required contributions.  Not paying full, required contributions is one of the surest ways to put a city on the path to financial ruin.  However, no one is advising employers to defer the additional costs imposed by the Fields decision, but Phoenix, Tucson, and other cities chose to do so because their elected leaders feel like they have no other choice since they simply can not afford the higher contributions right now.  Prepay your budget contributions?  Pay off the unfunded liability earlier?  With what funds?  If the cities had the extra money to do what the Task Force recommends, they would already being doing it.

The Task Force's recommended practices amounts to belling the cat.  The Task Force had a chance to offer some bold proposals and recommend some necessary reforms to PSPRS.  They did neither and wasted a valuable opportunity to have their voice heard.  Instead, they provided a list of embarrassingly impractical recommendations.  The work of the Task Force will be ignored by anyone serious about reforming PSPRS.

Monday, April 20, 2015

Invested in it: Chief Investment Officer Ryan Parham, PSPRS' investment strategy, and investment returns through February 2015

The following table shows PSPRS' investment returns, gross of fees*, versus the Russell 3000 for February 2015, the eighth month of the current fiscal year, with the June 2014 returns included for comparison:

Report PSPRS PSPRS Russell 3000 Russell 3000
Date Month End Fiscal YTD Month End Fiscal YTD
6/30/2014 0.78% 13.82% 2.51% 25.22%





7/31/2014 -0.67% -0.67% -1.97% -1.97%
8/31/2014 1.73% 1.05% 4.20% 2.14%
9/30/2014 -1.53% -0.49% -2.08% 0.01%
10/31/2014 0.40% -0.09% 2.75% 2.76%
11/30/2014 0.92% 0.82% 2.42% 5.25%
12/31/2014 -0.18% 0.64% 0.00% 5.25%
1/31/2015 0.01% 0.65% -2.78% 2.32%
2/28/2015 1.91% 2.58% 5.79% 8.25%

There is usually about a two-month lag in PSPRS reporting its investment returns.  There is not much new to report here.  PSPRS still lags the Russell 3000 and will be hard-pressed to achieve it 7.85% expected rate of return (ERR) by June 30, 2015, especially when we consider that the Russell 3000 lost one percent in March 2015.

I suppose now is as good a time as any to take stock of PSPRS' new investment strategy, which moved away a domestic equity-heavy, stock-picking portfolio to a more diversified and balanced approach.  In the 2012 Annual Report Summary, Chief Investment Officer Ryan Parham wrote:
Recent stress tests of on our portfolio indicate that we will capture approximately 70% of a strong up-market but only approximately 40% of a strong down-market.  Preventing that see-saw of returns produces a superior long term compounded return.This has been a key feature of the endowment investment universe which has historically produced better returns than public pensions.
Is the new strategy working as Mr. Parham's stress tests predicted?  Yes and no.  For fiscal year (FY) 2014, PSPRS captured 54.80% of the Russell 3000.  This is not 70%, but we must remember that PSPRS was never 100% invested in US equities, so it is not fair to compare it 100% vis-a-vis the Russell 3000.  Mr. Parham wrote in the 2013 Annual Report Summary , "At times more than 70% of the total fund was invested in U.S. large cap stocks." The maximum appears to be at the end of FY 2000 when PSPRS was 77.61% invested in common stock of what looked to be all US companies.  With this in mind, the 54.80% captured may be considered successful. 

However, for the current fiscal year to date, PSPRS is only capturing 31.27% of the Russell 3000 and failing to work as predicted.  In the three months that had a negative return, two were less than 40% of the monthly loss of the Russell 3000.  The third month grossly exceed the loss threshold at 73.55%.  In the four months that had a positive return, the highest was only 41.19% of the monthly gain of the Russell 3000. Depending on whether you consider the month in which the Russell 3000 had a zero return a loss or gain, PSPRS could have succeeded or failed.

While it may be too early to tell about the long-term prospects of PSPRS' new strategy, it did not stop Mr. Parham from boasting about the new strategy in the 2014 Annual Report Summary:
The Trust’s portfolio returns for the fiscal year ending June 30, 2014 continue to come from many diversified sources (10 separate asset classes.) We expect that diversification to help us to capture most of strong positive markets and to protect us from the worst of devastating negative markets. This was demonstrated in 2014 where we captured almost 3/4 of the returns of stock heavy portfolios. But in Q3 2014, when stocks were hard hit we had only 1/3 of the losses of those portfolios.
So if we extrapolate from Mr. Parham's rosy assessment of FY 2014, the Russell just needs to average to 14.32% every year in order for PSPRS to reach its 7.85% ERR (54.80% of 14.32%) every year.  In order to reach 9%, the Russell 3000 needs to just average 16.42% each year.  No problem, right?  The current 10-year annual rate of return on the Russell 3000 is 8.80%.  It will be interesting to see what new excuses Mr. Parham makes in the 2015 Annual Report Summary when PSPRS cannot even achieve its ERR for the current fiscal year.

* Returns, gross of fees, are used because PSPRS usually does not report returns, net of fees paid to outside agencies, except on the final report of the fiscal year.  The past two years fees have reduced the final annual reported return by about one-half of a percent.

Monday, March 23, 2015

PSPRS investment returns through January 2015

The following table shows PSPRS' investment returns, gross of fees*, versus the Russell 3000 for January 2015, the seventh month of the current fiscal year, with the June 2014 returns included for comparison:

Report PSPRS PSPRS Russell 3000 Russell 3000
Date Month End Fiscal YTD Month End Fiscal YTD
6/30/2014 0.78% 13.82% 2.51% 25.22%





7/31/2014 -0.67% -0.67% -1.97% -1.97%
8/31/2014 1.73% 1.05% 4.20% 2.14%
9/30/2014 -1.53% -0.49% -2.08% 0.01%
10/31/2014 0.40% -0.09% 2.75% 2.76%
11/30/2014 0.92% 0.82% 2.42% 5.25%
12/31/2014 -0.18% 0.64% 0.00% 5.25%
1/31/2015 0.01% 0.65% -2.78% 2.32%

There is usually about a two-month lag in PSPRS reporting its investment returns.  Seven months into the fiscal year and PSPRS has essentially broken even.  PSPRS' non-US equity portfolio had better returns than the US equity portfolio in January, but it still stands at -8.67% for the fiscal year to date while US equities still show a positive return of 1.42%.  The Real Assets portfolio remains the only other asset class with a negative return for the fiscal year at -3.00%.

PSPRS' monthly return for February 2015 should be significantly better.  The Russell 3000 shows a huge 5.79% gain for February 2015, which hopefully will help PSPRS make up for a lot of lost ground this fiscal year.  March 2015 has been another volatile month, and as of the last close on March 20, 2015, the Russell 3000 is up 0.69% month-to-date.  It will still be difficult for PSPRS to achieve its expected rate of return of 7.85% by fiscal year end, but I am little more optimistic than I was a month ago.

* Returns, gross of fees, are used because PSPRS usually does not report returns, net of fees paid to outside agencies, except on the final report of the fiscal year.  The past two years fees have reduced the final annual reported return by about one-half of a percent.

Tuesday, March 10, 2015

We have a new Administrator, eh: The Board of Trustees goes north to keep PSPRS from heading south

The Arizona Republic yesterday published this article by Paul Giblin, Canadian to lead Arizona public safety retirement fund.  Kevin Olineck, the Vice-president, Member Experience for the British Columbia Pension Corporation (BCPC), has been selected as the new PSPRS Administrator.  He will permanently replace James Hacking, who was forced out of the job in July 2014 after it was discovered that he had given staff raises without approval from the Arizona Department of Administration, as required by law.  Mr. Olineck, along with Jared Smout, the current Acting Administrator, and Hewlett-Packard Enterprise Services retirement portfolio executive Amy Timmons, were the final three candidates.  A fourth candidate, Maricopa County Supervisor Andrew Kunasek, dropped out before the Board of Trustees made its final decision.  Following is Mr. Olineck's biography from the BCPC website:
Kevin Olineck joined the BC Pension Corporation as Vice-President, Client Services Division, in May 2009. He is now Vice-President of the Member Experience Division. Prior to joining the Pension Corporation he worked as Vice-President, Pension Services, for the Alberta Pension Services Corporation. In addition to his experience in public sector pension administration, Kevin has held management positions within the Pension and Investment Management Division at Canada Life Assurance Company/Crown Life Insurance Company.
Since joining the corporation, Kevin has focused on defining and implementing a service delivery model for the corporation’s clients as well as providing strategic leadership to the Member Experience Division, which has responsibility for plan board, member and employer communications.
Kevin has a degree in Public Administration from the University of Saskatchewan, a Certified Employee Benefits Specialist (CEBS) designation and a Pension Plan Administration Certificate (PPAC). He has been a member of the Canadian Pension Benefits Institute (CPBI) for many years and is currently a member of the Pacific Council.
Mr. Olineck seems to be an extremely well-qualified choice, and I am personally glad that they brought in a complete outsider, not from within PSPRS, not from the Phoenix valley, not from Arizona, and not even from the the United States.  Mr. Olineck will bring a fresh perspective from his position in British Columbia (BC), Canada, and he is not beholden to any political party, union, business, family member, or other outside connection.  Being a Canadian citizen with a proven track record in his home country, he is probably not even that concerned about his pay and benefits since he could return to Canada and would be hired for another job in about two minutes if he decides to leave the PSPRS job.  Hopefully, this will give him the independence to bring about necessary changes to PSPRS.

BCPC, is an umbrella administrator over BC's five public pension plans.  Unfortunately, BCPC has no pension like PSPRS that covers only public safety employees, so there is no real counterpart to PSPRS.  However, for comparison, the BCPC Municipal Pension Plan (MPP), which is the one that seems to cover most law enforcement and firefighters in BC, will have to do.

The last MPP annual report on the website is for the calendar year 2013.  MPP earned 15.1% that year and had a 5-year and 10-year annualized rate of 9.8% and 7.5%, respectively.  On December 31, 2013 PSPRS had a 1-year, 5-year, and 10-year annualized rate of return of 13.26%, 10.44%, and 5.86%, respectively.  This is not an overly unfavorable comparison with PSPRS.  The MPP is much better funded, though, at 96.5% at the end of 2012.  It was 95% and 97% funded at the end of 2009 and 2006, respectively.  There are several reasons for the MPP's better funding ratio.

The MPP does not guarantee COLA's, which are awarded based on the Board of Trustees' analysis of the plan's ability to pay for them, and they are limited to the rate of inflation as expressed in the Consumer Price Index (CPI).  They also have an independent actuarial valuation every three years to assess the plan's financial health and adjust contribution rates accordingly.  Annual contribution rates are split equally between employees and employers.   Contribution rates are also higher on annual salary over a certain limit.  The MPP uses a high-five year average to determine the pension benefit.  There are multiple "membership groups" but it looks like the newest membership group, Group 5, includes newer firefighters and law enforcement personnel.  In 2013 Group 5 had a contribution rate of 9.74% on salary up to $51,100, and a contribution rate of 11.24% on everything over that.  The Group 5 multiplier is 2.33%, which after 25 years would be 4.25% less than the 62.5% you would get in PSPRS, but it would give you a higher benefit if you (can) retire between 20 and 24 years.

As can be seen, the MPP operates more like the Arizona State Retirement System (ASRS) than PSPRS, and both the MPP and ASRS are in much better financial shape than PSPRS.  This is not by accident.  I previously wrote about the wisdom of ASRS here, but these passages from the "Message from the Trustees," in the 2014 annual report from one of the other BCPC plans, the Public Service Pension, distill some of that wisdom down:
The plan is responsible. 
From plan design to the way we as trustees invest and tolerate risk, we act responsibly. Our decisions are made after careful consideration; our responses to challenges are well considered, well debated and well thought out. Trustees are always keeping an eye on the future.  How else is the plan responsible?  We act responsibly by closely monitoring the plan through regular actuarial valuations and adjusting contribution rates as necessary. We demonstrate the success of our monitoring and rate adjustments by the fact our valuations have shown the plan to be at or near 100 per cent funded for more than a decade.  Agencies that establish credit ratings for governments appreciate the value of BC’s strong public sector pension plans like the Public Service Pension Plan. These agencies cite this strength as a factor in supporting BC’s triple-A credit rating. 
The plan is fair. 
As trustees, we consider fairness when making our decisions. The law mandates us to act evenhandedly and consider the interests of all members when making decisions. Our backgrounds reflect the various employer and member groups participating in the plan. We are diverse, but act together in the best interest of all members.The plan is fair to members of all generations because it is pre-funded. This means each generation pays in advance for its own pensions.  On a broader scale, the plan is fair to taxpayers. Why? Because employees bear more than 50 per cent of the plan’s risks. While contributions to the basic pension benefit are shared 50/50, plan members bear all the risk associated with contingent benefits such as inflation adjustments and group benefits.
Responsibility, careful consideration of decisions, keeping an eye on the future, acting together in everyone's best interest, fairness to all generations, fairness to taxpayers?  What a radical philosophy!  Perhaps Mr. Olineck should nail these passages to the door of PSPRS' headquarters, so that those like the Professional Fire Fighters of Arizona (PFFA), whose horrible reform plan is the antithesis of responsibility and fairness, will know that things must change if PSPRS is to survive.

Congratulations on your new job, Mr. Olineck, and best of luck.  You All of us are going to need it.


Wednesday, March 4, 2015

Why you should hate the Professional Fire Fighters of Arizona's (PFFA) PSPRS reform proposal, Part II

In the last post we talked about why the Professional Fire Fighters of Arizona (PFFA) PSPRS pension reform proposal was bad for active PSPRS members.  In this post, we will talk about why it is bad for retirees.  This is more complicated than talking about the implications for active workers for a couple reasons.

First, and most importantly if you are a retiree, COLA's are not an abstraction to you.  COLA's are a very real source of income that you may already be relying on, and you retired with an expectation of receiving this income.  A retiree has a lot more at stake in the here and now than someone who has 25 or 30 years left before he or she retires.  Second, it is necessary to have a basis of comparison in order to make an informed decision about the PFFA proposal.  Since no one can see into the future about what economic conditions, I have created a table for some comparison:

Fiscal Year EndPSPRS Rate of ReturnPSPRS Funding LevelExcess Earnings COLA PFFA 2% COLA FormulaSB 1609 COLA Formula
199822.23%116.3% $        81.95  $      40.98  $    81.95
199917.70%120.3% $        87.37  $      43.69  $    87.37
200012.31%124.7% $        93.24  $      46.62  $    93.24
20016.02%126.9% $        98.17  $      49.09  $          -  
2002-15.00%113.0% $      102.53  $      51.27  $          -  
20036.70%100.9% $      111.90  $      55.95  $          -  
200414.97%92.4% $      116.82  $      58.41  $  116.82
20059.11%83.2% $      121.76  $      60.88  $          -  
20068.30%77.6% $      127.06  $      63.53  $          -  
200717.06%66.4% $      134.34  $      67.17  $    83.96
2008-7.27%66.5% $      138.66  $      69.33  $          -  
2009-17.72%68.2% $      146.74  $      73.37  $          -  
201013.47%65.8% $      152.84  $      76.42  $    95.53
201117.37%61.9% $      159.13  $      79.57  $    79.57
2012*-0.79%58.6% $      121.19  $      87.47  $          -  
2013*10.64%57.1% $        65.20  $      87.65  $          -  
201413.20%49.2%



Total


 $   1,858.90  $ 1,011.38  $  638.43 

The table shows a comparison of the different monthly COLA increases that have or would have been paid under the current excess earnings formula, the PFFA 2% formula, and the SB 1609 formula.  I went back to 1998 because that is as far as the reports go back on PSPRS' website.  However, it works out well because it covers a period several years before the first big financial crisis up until fiscal year (FY) 2013.  Please keep in mind that the COLA amounts are determined in the FY listed but paid in the next fiscal year.   I placed an asterisk (*) by FY's 2012 and 2013 because the excess earnings COLA amounts appear to be less than 4% of the average normal retirement amount, so this was not the maximum COLA allowed under the excess earnings formula.  The actuarial report for FY 2014 is out, but the annual report has not been released.  I do not know what the COLA amounts would be going into FY 2015, which is already 8 months in, though there would be no COLA under the SB 1609 formula and some COLA paid under both the excess earnings formula and the PFFA 2% formula.  In FY 2011 and prior, it appears that all the amounts represent the maximum 4% COLA allowed under the excess earnings formula.

Before we go further, here is a description of each COLA formula:
  1. The excess earnings model takes half of any earnings over 9% in a fiscal year and sequesters it in a fund used exclusively to pay COLA's.  Up to a 4% COLA can be paid each year.
  2. The PFFA 2% formula is still just a proposal, but it would limit COLA's to up to 2% based on available funds taken from active workers' pay, and it would delay COLA's for up to seven years or age 60, which ever is sooner.  There will be a three-year period where no COLA's will be paid in order to build a reserve, and no more than 25% of the reserve could be used in one year.
  3. The SB 1609 formula, which is being contested in court but is technically still in effect for anyone who was not already retired when SB 1609 went into effect, uses a sliding scale for COLA's based on both the past FY's earnings and the funding level of PSPRS.  The scale goes as follows:
    • If the ratio of the actuarial value of assets to liabilities is 60-64% and the total return is more than 10.5% for the priorfiscal year, 2% maximum increase to all eligible retirees and survivors.
    •  If the ratio of the actuarial value of assets to liabilities is 65-69% and the total return is more than 10.5% for the prior fiscal year, 2.5% maximum increase to all eligible retirees and survivors.
    • If the ratio of the actuarial value of assets to liabilities is 70-74% and the total return is more than 10.5% for the priorfiscal year, 3% maximum increase to all eligible retirees and survivors.
    • If the ratio of the actuarial value of assets to liabilities is 75-79% and the total return is more than 10.5% for the prior fiscal year, 3.5% maximum increase to all eligible retirees and survivor.
    • If the ratio of the actuarial value of assets to liabilities is 80% or more and the total return is more than 10.5% for the prior fiscal year, 4% maximum increase to all eligible retirees and survivors

So we can see from the table that the excess earnings formula is, by far, the most generous to retirees.  The average normal retirement benefit in 1998 was $2,050/month.  The excess earnings formula increased this by about 90% in 16 years.  The PFFA 2% formula represents a 49% increase, and the SB 1609 formula represents a 31% increase.

If we use the COLA figures from Social Security, which are based on the Consumer Price Index, we can see inflation rates as follows and how they would affect the original $2,050/month benefit:

Year     %      COLA    Benefit 
1998 1.30%  $   26.65  $  2,076.65
1999 2.50%  $   51.92  $  2,128.57
2000 3.50%  $   74.50  $  2,203.07
2001 2.60%  $   57.28  $  2,260.35
2002 1.40%  $   31.64  $  2,291.99
2003 2.10%  $   48.13  $  2,340.12
2004 2.70%  $   63.18  $  2,403.31
2005 4.10%  $   98.54  $  2,501.84
2006 3.30%  $   82.56  $  2,584.40
2007 2.30%  $   59.44  $  2,643.84
2008 5.80%  $ 153.34  $  2,797.19
2009 0.00%  $        -    $  2,797.19
2010 0.00%  $        -    $  2,797.19
2011 3.60%  $ 100.70  $  2,897.88
2012 1.70%  $   49.26  $  2,947.15
2013 1.50%  $   44.21  $  2,991.36

Total                         $ 941.36     

This shows that the PFFA 2% formula appears to be the formula that most closely matches the inflation of the period.  The 2013 benefit represents a 46% increase from the original $2,050 monthly benefit.  During this period, inflation averaged about 2.4% a year.  As can be seen, the excess earnings COLA is way out of sync with inflation, while the SB 1609 formula is lagging behind inflation.  So far, it looks like the PFFA proposal is not too bad, but let's look back at the 16 years prior to 1998.  During the period between 1982 and 1997, inflation averaged 3.6%.  This time period caught the very tail end of the "Great Inflation" era of the 1970's and early 1980's in which inflation peaked at 14.3% in 1980.


Year     %    COLA  Benefit 
1982 7.40%  $   151.70  $  2,201.70
1983 3.50%  $     77.06  $  2,278.76
1984 3.50%  $     79.76  $  2,358.52
1985 3.10%  $     73.11  $  2,431.63
1986 1.30%  $     31.61  $  2,463.24
1987 4.20%  $   103.46  $  2,566.70
1988 4.00%  $   102.67  $  2,669.37
1989 4.70%  $   125.46  $  2,794.83
1990 5.40%  $   150.92  $  2,945.75
1991 3.70%  $   108.99  $  3,054.74
1992 3.00%  $     91.64  $  3,146.38
1993 2.60%  $     81.81  $  3,228.19
1994 2.80%  $     90.39  $  3,318.58
1995 2.60%  $     86.28  $  3,404.86
1996 2.90%  $     98.74  $  3,503.60
1997 2.10%  $     73.58  $  3,577.18




Total
 $1,527.18

This is where we have to start thinking about unintended consequences.  Using the inflation numbers from 1984 to 1997, you would need about $3,577 in 1997 to equal what you could buy in 1984 with your starting $2,050 monthly benefit.  The PFFA 2% proposal would only provide you with $2,814, leaving you with about 79% of your original purchasing power.  If we use 4% average inflation over the 16-year period, you would need $3,840 just to keep up with inflation, while the PFFA 2% proposal would still leave you with only $2,814 and now with only 73% of your original purchasing power.  Small changes in inflation can make a big difference.  Of course, higher inflation over longer periods of time will leave you even poorer.  Social Security Administration shows annual inflation in 1979, 1980, and 1981 of 9.9%, 14.3%, and 11.2%, respectively. 

The most obvious argument for the PFFA proposal would be that the table still shows that it would pay more than the SB 1609 formula, especially since SB 1609 requires PSPRS to meet two benchmarks, 60% funding level and 10.5% rate of return, before a COLA is paid.  That is a fair enough criticism that needs further analysis.

 FY 2014 shows PSPRS with only a 49.2% funding level, but we must remember that if part of SB 1609 had not been overturned by the Arizona Supreme Court, the funding level would higher.  If the excess earnings model had not been reinstated for those retired when SB 1609 went into effect, PSPRS' funding level would be 6.1% higher at 55.3%.  If you add back in the 2.7% health insurance portion that must now be separated by IRS rules but was counted as part of the total funding level when SB 1609 when into effect, PSPRS would now sit at a 58% funding level.  This is not quite 60% but is close, and it is an increase over the previous year's funding level of 57.1%, which means it was moving in the right direction before the Fields decision and would soon be over 60%.  Obviously another major market downturn would send the funding ratio back down, but this would take us back to the existential crisis of PSPRS' ultimate survival.

Meeting the 10.5% threshold is more problematic. Except for 2013 and 2014, the reason the SB 1609 formula would have paid no COLA is because PSPRS did not hit the 10.5% rate of return, and since 2001 it would have paid COLA's in only four of the last 13 years. However, we must remember several things.  First is that PSPRS needs some excess earnings to pay down its deficit.  It can be debated how much this margin should be, but even with the 10.5% threshold, this represents only a 2.65% excess margin over the expected rate of return (ERR) of 7.85% available to pay down current liabilities and allow for a cushion of excess earnings against years when the fund earns less than 7.85%.  The true stupidity of the excess earnings formula is that it deemed any earnings over the old ERR of 9% as "excess" and allowed half of that amount to be set aside for COLA's as if PSRPS would never have a time when it would earn less than its ERR and need some higher-than-expected earnings to make up for shortfalls in bad years.  Second, we have to remember that the time period we are considering here is the worst financial period since the Great Depression.  In the absolute worst of financial times, the SB 1609 formula would still pay COLA's while working to bring PSPRS back to solvency.  Third, once PSPRS' funding ratio begins to rise, it will be able to pay higher COLA amounts, which could make up for years when a COLA was not paid because the ERR did not exceed 10.5%.  Once PSPRS, reaches 80% funding, the COLA will be 4%, double the 2% limit of the PFFA formula.

Lastly, we once again must consider the unintended consequences of inflation.  We have already seen how a period of sustained inflation above 2% would slowly rob retirees of the value of their benefits.  We also have to think about what inflation will do to rates of return.  Higher sustained inflation means that investors like PSPRS will find it easier to get higher rates on low-risk and risk-free investments.  This means the other riskier investment in its portfolio will likely see a rise in their rates of return as well.  All this means that PSPRS will see it rates of return increase with no real effort on their part; inflation will take care of that for them.  You can check out this chart of historic certificate of deposit (CD) rates of return at Bankrate.com to see what I am talking about.  This will make it easier to reach the 10.5% threshold necessary to pay COLA's under the SB 1609 formula.  Under the PFFA formula, regardless of what PSPRS earns, retirees will receive 2% year in, year out, regardless of what PSPRS earns.  Remember that the PFFA reform proposal will make its changes via constitutional amendment, permanently locking them in.  Any change to the 2% formula would likely be met with resistance from other interests both inside and outside of PSPRS and would require another voter-approved initiative to change.

I am an active worker, and my perspective is different from someone already retired who is only looking at his or her monthly benefit check.  To some it may seem like a better deal to just accept the 2% annual COLA and not take your chances, but I think that is shortsighted.  In the end, PSPRS is a debtor to all its members, active and retired, and inflation helps debtors by allowing them to pay off obligations in the future with devalued dollars.  This is a stealth way for PSPRS to achieve solvency while its retirees slowly get poorer.  Also, remember that the PFFA proposal places a three-year hold on COLA's for everyone, and it will delay COLA's for up to seven years for new retirees.  There is also no guarantee that the COLA will be 2% every year.  There are a lot of financial angles to think about if you are a retiree.

I am not defending the SB 1609 COLA formula because I think it is perfect.  I am on record as advocating an annual COLA determination by the Board of Trustees (or another independent board) that would take into consideration PSPRS' financial condition, inflationary conditions, and rates of return to make sure retirees can be kept as whole as possible in the face of inflation while not shafting taxpayers and active and future workers.  SB 1609, which came out of the Arizona Legislature, is simply better designed, fairer, and actually made an effort to equitably share some necessary sacrifices.  The PFFA's reform proposal is a cynical, political ploy that tempts its retirees to sell out their younger brothers and sisters for a "guaranteed" 2% COLA.

I apologize for the length of this post, but as I said at the beginning, the PFFA's Operation Blue Falcon is more complicated as it relates to retirees.   Whether you agree with my conclusions or not, I hope that the numbers will give you some better information to decide what is best for you.  Rest assured that there will be more to come about this in future posts.

Monday, February 23, 2015

Why you should hate the Professional Fire Fighters of Arizona's (PFFA) PSPRS reform proposal, Part I

The art of economics consists in looking not merely at the immediate but at the larger effects of any act or policy: it consists in tracing the consequences of that policy not merely for one group but for all groups. 

                                                               Henry Hazlitt,  
                                                               Economics in One Lesson

If you are an active employee who is keeping an open mind about the Professional Fire Fighters of Arizona (PFFA) PSPRS reform proposal, you may be asking yourself this: 
If SB 1609 already requires me to pay increased contributions into PSPRS, why do I care whether the extra contribution amount goes to pay COLA's to retirees or is used to pay down PSPRS' deficit since it comes out of my check either way?
Okay, maybe you weren't asking that question, but it does allow me to go into some of the unintended consequences of the PFFA's reform proposal.

PFFA President Bryan Jeffries has stated that the PFFA reform proposal, ". . . would fund retirees' cost of living adjustments out of the pockets of current working public safety workers, not taxpayers."  This would be done by taking the aforementioned extra contribution amount already being paid by active workers (currently 3.4%, but topping out at 4% on July 1, 2015) to pay down PSPRS' deficit, and instead, use it to fund COLA's for retirees.  The destructive excess earnings model of paying COLA's would be eliminated.  Active workers would see no net change in their paychecks, as they have to pay the additional 4% for their whole careers anyway; taxpayers would be off the hook for the COLA's; and retirees would still be able to get COLA's, though they will be at a reduced amount.  Win,win, and not a total loss, right?

Not quite.  If you are an active employee making contributions into PSPRS, it is true that your contribution will not change.  However, you will have to consider the unintended consequences of your career earnings becoming the dedicated source of income for retiree COLA's.  Governments (and public employee unions) love to have dedicated sources of income.  This is usually done via some type of tax like a gas tax hike for road repairs, a tax on cigarettes for health programs, or a sales tax increase for some particular program (like was attempted in 2012 with Proposition 204, which would have made the temporary one cent sales tax increase permanent to fund education).

The dedicated funding source is fine as long as the economy is good.  When there is a downturn, the tax will remain, even if the taxpayers are finding their own income diminished.  If we are talking about gas, cigarette, or even sales tax, the taxpayer has some means to offset their loss of income by driving, smoking, or buying less in general.  But what happens to active employees when there is an economic downturn?

Active employees, who have been dutifully funding retiree COLA's with 4% of their earnings, will now see the unintended consequences of the PFFA reform proposal.  Their employers, suffering from decreased tax revenues, will have to find ways to trim their budgets.  This is particularly harsh for those in public safety because economic downturns usually mean that PSPRS suffers investment losses, which in turn, means higher annual required contributions (ARC's) for employers. The employers are hit by this double squeeze of lower tax revenue and higher ARC's.  This spells disaster for active public safety employees.

Wages and benefits are by far the largest part of law enforcement and fire service budgets.  When an employer has to trim public safety budgets, it really has no other option than reducing payroll costs, either individually or in the aggregate.  While it may be good to be the recipient of a dedicated source of income, it is not so good to to be the dedicated source of income.  Active employees will find this out if the PFFA's succeeds in making their proposal part of the Arizona Constitution.

If there is another financial crisis, active employees are going to get hammered because they will be the only source of cost savings in the budget.  However, retirees may not even notice the financial hardship visited on active employees because of the design of the PFFA reform proposal.  Looking at the fiscal year (FY) 2014 actuarial report, we can see that active members contgributed about $152 million into PSPRS.  If COLA's were being paid per the PFFA reform proposal, 4% of this amount, or about $6 million, could be used to pay retiree COLA's.  There were about 10,500 retirees at the end of FY 2014 with an average yearly retirement benefit of $51,600.  The $6 million allocated for COLA's would not be enough to pay a full 2% to all retirees.  $6 million divided among 10,500 retirees would only be about a $571 annual increase for each retiree.

Now let's redo these calculations.  Suppose a bad economy caused employers to give our active employees a 2% pay cut in FY 2014.  This would reduce our total active member contributions to about $149 million from $152 million.  4% of the reduced amount would be about $5.96 million.  With this lower amount to pay COLA's, retirees would receive a $567 annual increase versus $571.

However, the average FY 2014 salary of our active employees is about $75,000 per year.  A 2% pay reduction means that our average employee loses $1,500 a year.  Retirees will see their COLA reduced by $0.33 per month while the average active employee will see his monthly salary drop by $125.  Even if we drop the active employees' pay 10% ($625 a month), our retiree will only see his monthly COLA reduced by about $4.17 a month.

Here we can see the truly insidious effects of the PFFA reform proposal.  It shifts not only the burden of retiree COLA's on to active employees, but also the punishing effects of any future financial crises.  Retirees will be insulated from most of the effects of any financial crisis since any reduction in their COLA's will be minimal in comparison to active employees.  Active employees will take the brunt of nearly all the downside of financial downturns.  Retirees will take virtually none.  This is the same problem with the current excess earnings COLA model that has made it such a problem for PSPRS: all the upside to retirees, all the downside to PSPRS.  Only now, instead of the costs of the bad model hitting PSPRS, the PFFA wants active employees to absorb them.

The PFFA's desire to make active employees the dedicated source of income for retiree COLA's is so egregious that it is could be used as an example of historian Robert Conquest's Third Law of Politics which says, "The simplest way to explain the behavior of any bureaucratic organization is to assume that it is controlled by a cabal of its enemies."  With a friend like the PFFA . . .

In the next post we will discuss how this plan is bad for retirees as well.