Monday, August 31, 2015

Meet the new PSPRS boss, same as the old PSPRS boss

In the latest missive from the bunker comes this underwhelming news:

         August 27, 2015
PSPRS veteran tapped to run $8 billion trust
Board Chairman: Smout ‘exemplary’ during uncertainty 
PHOENIX – The state’s Public Safety Personnel Retirement System Board of Trustees appointed Jared Smout to lead the state’s multi-billion dollar trust that invests and provides retirement benefits to public safety employees, corrections officers, judges and elected officials.
Smout, who has served as interim system administrator since July 2014 and has served PSPRS for more than 18 years, was appointed on Aug. 26 by a vote of the seven-member board led by Chairman Brian Tobin.
Tobin, a veteran City of Phoenix firefighter, praised Smout’s performance and dedication displayed during an era marked by unjustified accusations against the system, legal uncertainty and the added diplomatic task of encouraging reforms aimed at providing financial stability to the trust.
“I think he’s done an exemplary job under very difficult circumstances,” Tobin said. “He has the experience, the education and the skills, and he will serve this state and its public safety employees well in this vitally important position.”
During his tenure as deputy system administrator and acting system administrator, Smout has continued to oversee PSPRS’ nationally recognized investment strategy that seeks steady returns coupled with resistance to market volatility.
“I deeply appreciate the Board’s confidence in allowing me to continue in this role. I absolutely love my job and am grateful every day for the opportunity to serve those who serve this state,” Smout said. “We have a lot to be proud of and we will continue to improve the system, our relationships and our ability to deliver long-term pension stability.”
The risk-averse strategy implemented by PSPRS seeks to diversify assets and reduce exposure to publicly-traded equities, the greatest driver of market fluctuations. The trust performed admirably in fiscal years 2013 and 2014, posting net gains of 11 percent and 13.3 percent, respectively, despite assuming far less risk than the vast majority of public pension plans.
Additionally, PSPRS is expected to outperform more than 80 percent of 66 comparably sized pension trusts for fiscal year 2015, a year marked by low returns for trusts with stock-heavy portfolios.
The PSPRS trust combined with the Corrections Officers Retirement Plan (CORP) and the Elected Officials Retirement Plan (EORP) is valued at roughly $8.3 billion and provides retirement, disability and survivor benefits to approximately 50,000 retired and active members.
While I believe that former PSPRS Administrator James Hacking was unfairly scapegoated for PSPRS' problems and forced to fall on his sword and resign to appease some PSPRS critics, his departure was an opportunity to bring in someone new with a better track record at another pension system or financial organization.  I thought we would have that when in March 2015 PSPRS announced that Kevin Olineck, a vice-president with the British Columbia Pension Corporation (BCPC), was chosen to be the new PSPRS Administrator.  The BCPC is in much, much better financial shape than PSPRS, and no doubt has many good practices that Mr. Olineck could have brought with him to PSPRS.

Unfortunately, this was not to be as Mr. Olineck strangely could not get a visa to work in the United States, and the Board of Trustees' choice went from international to inter-office.  While the press release touts Mr. Smout's 18-year tenure as a plus, a look at his resume shows that with the exception of a three-month stint as acting finance director for the Salt Lake City Public Library, he has worked almost exclusively for PSPRS, starting as an administrative assistant in 1997 and working his way up to Deputy Administrator in 2011.  While he has an admirable record of career advancement in PSPRS, the bulk of his time with PSPRS coincides with its worst financial performance and most problematic management.  Also, according to the August 27, 2015 Arizona Republic article, Arizona public-safety pension trust picks insider as new leader, by Craig Harris, Mr. Smout signed off on the illegal raises that cost Mr. Hacking his job.

Compared to Mr. Olineck or Deric Righter, a former CEO of ThyssenKrupp USA, the other finalist for the Administrator job and another person with a more varied and successful career in finance and management, Mr. Smout appears, far and away, the least likely of the three to implement change at PSPRS.  Closer to home, we can compare Mr. Smout to Paul Matson, Director of the much better managed and much better performing Arizona State Retirement System (ASRS).  Mr. Matson's ASRS biography shows he worked six years for the Alberta, Canada Treasury before joining ASRS, then spent eight years as ASRS Chief Investment Officer before becoming Director.  ASRS' Trustees obviously saw the value in a more well-rounded career with exposure to other systems when they hired and promoted Mr. Matson.  It is unfortunate the PSPRS Board of Trustees did not see things the same way once they knew that Mr. Olineck was unable to take the job.

Trustees Lauren Kingry and Bill Davis, to their credit, voted against Mr. Smout's selection, with Mr. Kingry stating that he wanted to "to examine the available candidate pool."  Unfortunately, the other five Trustees voted to select Mr. Smout without even that cursory amount of due diligence.  Of course, the Board already bungled a months-long hiring process by offering the job to someone who could not work in the United States, a piece of information which was conspicuously omitted from the press release.  They also see fit to boast about their fiscal year 2015 performance, despite the fact that it will only be about half the assumed rate of return, another piece of information missing from the press release.  If this is the mindset of the Board of Trustees, maybe the next thing to be replaced should be some of the Trustees.

Friday, August 28, 2015

PSPRS investment returns through June 2015 (the all-important end of the fiscal year)

The following table shows PSPRS' investment returns, gross of fees*, versus the Russell 3000 for June 2015, the end of the current fiscal year (FY), 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%
3/31/2015 0.83% 3.42% -1.02% 7.15%
4/30/2015 0.95% 4.40% 0.45% 7.63%
5/31/2015 0.54% (est) 4.94% (est) 1.38% 9.01% (est)
6/30/2015 -0.73% 4.21% -1.67% 7.29%

There is usually about a two-month lag in PSPRS reporting its investment returns.  The PSPRS Board of Trustees did not have a July meeting so I do not have exact numbers for May 2015 and estimated the returns based on April and June.  PSPRS returns reverted back to their normal pattern in May and June with gains lagging when the Russell 3000 is positive and limiting its losses when the Russell 3000 is negative.  As can be seen, PSPRS did not even meet its expected rate of return (ERR) of 7.85% much less the COLA threshold, which, as was discussed earlier here, means no COLA will be paid in the current FY.  The returns, net of fees, will probably be around 3.70% for the fiscal year.

For the fiscal year, all but two of PSPRS' asset classes showed a positive return, but of the positive returners, only the private equity class met or bested the ERR with a 14.05% FY return.  The non-US equity and real assets with -4.58% and -3.55% FY returns, respectively, are the two asset classes with losses for the FY.  PSPRS FY returns are a very mixed bag.  Looking at two years of PSPRS' risk-averse strategy, PSPRS' FY 2014 return was 54.79% of the Russell 3000, while PSPRS' FY 2015 return (estimated net of fees at 3.70%) was 50.75% of the Russell 3000.  If PSPRS' risk-averse strategy can only range between 50-55% of the Russell 3000 each year, it will be really tough for it to ever meet its ERR.  Even at the new 7.50% rate and getting to 55%, the Russell 3000 would have to return 13.64% just to meet the ERR.  Of course, this is limited data, but it is all we have to go on.

The Russell 3000 showed a 1.67% gain for July 2015, but as of August 27, 2015, the Russell 3000 has a monthly loss of -5.48%.  Who knows what could happen by the end of today and on the 31st?  It has been so volatile this month that almost nothing would surprise me.   Regardless, PSPRS likes to highlight the stress tests it has done on its portfolio as proof of how well-designed the portfolio is, so this month they may get a real, live stressor against which to check the design of the portfolio.

* 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.

Thursday, August 27, 2015

Why Prescott's PSPRS sales tax measure went down in defeat

Normally, a local election in a city of 40,000 people would not be of much interest to people outside its city limits, but the City of Prescott had an interesting issue on its ballot Tuesday.  Officially listed as Question 3, the City of Prescott ballot asked voters:
Shall the City of Prescott adopt a transaction privilege (sales) tax of fifty-five one-hundredths of one percent (0.55%), the restricted revenue from which shall be dedicated to the payment of the unfunded obligations of the city to the Arizona Public Safety Personnel Retirement Systems, taking effect on January 1, 2016, and continuing until the unfunded obligations of the city to the Systems are paid in full, including any associated financing of said obligations, but ending not later than December 31, 2035?
This attempt to pay off Prescott's PSPRS deficit via a 20-year sales tax increase was soundly defeated 56%-44%.  According to the Prescott Daily Courier, this defeat was in spite of the support of the current City Council and all but one of the candidates who ran for mayor and council seats.  Interestingly, in the only head-to-head race, the one candidate opposing the PSPRS sales tax, Harry Oberg, won the mayoral election against Dan Fraijo, a former Division Chief in the Phoenix Fire Department and a former Prescott Fire Chief, 51%-49%.

Two other tax measures were on the ballot as well.  A measure to increase a road tax from 0.75% to 1.0% was approved, 57%-43%, while a 0.08% tax to pay for open space was  rejected 58%-42%.  So there appears to be more here than an across-the-board rejection of tax increases.

Voters were given dire projections about draconian cuts to city services and lectured about their "responsibility" to pay a legally incurred debt, and yet in spite of this collective shaming by politicians, media personnel, business leaders, and sundry commentators, voters still overwhelming defeated this tax proposal.  It is funny to see the tut-tutting of the Prescott political class with comments such as:
Councilman Greg Lazzell: "There are going to be a lot of hard decisions and a lot of disappointed citizens."
Councilman Steve Blair: "People have the attitude that we have to live within our means, but it is going to involve some serious choices."
Former Councilman Malcolm Barrett, Jr.: Those against the PSPRS tax proposal "talked about sending a message, but the only message they're sending is that 'we're not going to pay our bills."
Councilwoman Jean Wilcox:  Those who voted against the PSPRS tax proposal "were duped by the Tea Party mentality, and don't understand that paying this tax will benefit the whole community."
Nothing like characterizing your constituents as infantile, ignorant deadbeats to win them over.  Compare this to the comments of Joe Pendergast, president of the opposition organization, Citizens Tax Committee:
"I think people have had enough of taxes unless they can be justified."
"My idea was, if [the PSPRS tax] did pass, the pressure is off the council."
"The council is in a little bit of a pickle, and citizens will be up in arms, and will pressure the council to pressure the Legislature (on reform)."
While I do not agree with Mr. Pendergast's reasoning since the Prescott City Council will have scant influence on the Arizona Legislature, except through the League of Arizona Cities and Towns, and barring bankruptcy, will still have to pay this debt, he is correct in pointing out the responsibility of the politicians in this problem.  As politicians are wont to do, they characterized and sold the solution to the PSPRS debt as a revenue problem, never making any concessions on the spending side.

Why did the voters approve the road tax by the same margin they rejected the PSPRS tax, if "they were duped by the Tea Party mentality"?  It is because, in the case of infrastructure, the revenues will have to match the spending.  X dollars will get you X amount of construction and repairs, based on an open bid contract system.  Streets are not paid wages, do not collectively bargain, nor spike their pensions.  Compare this to the PSPRS tax.  While the taxes will have to go toward the PSPRS debt, what drove that debt in the first place?  Wage and benefit policies.  Technically, this PSPRS sales tax is restricted revenue, but the rest of the city's general fund is not.

Without a commitment from the city government to control the wage and benefit policies driving PSPRS costs, what will keep the PSPRS tax from being funneled back into the very spending that caused the deficit in the first place?  I certainly would not begrudge the fire and police unions for working to increase their pensionable wages and benefits as this is what unions are supposed to do.  However, how do you go to someone on a fixed or low income and ask them to pay a higher sales tax without some guarantee that the cost drivers of the tax will be managed as well?  The Prescott government is asking taxpayers to give them money without any transparent mechanism for controlling future pension costs.

Perhaps if the PSPRS tax measure was tied to some concession like a union-negotiated agreement like an employee contribution rate increase or a limiting of pensionable wages to base pay only, it would have shown voters that the city and its public safety employees were willing to sacrifice alongside taxpayers.  This would show a serious effort to pay down the deficit.  The phased-in employer contribution rates for the Prescott Fire Department and the Prescott Police Department are 63.44% (non-phased 74.49%) and 55.12% (non-phased 66.16%), respectively, and I am not sure these rates for Prescott Fire, taken from the 2014 actuarial reports include all the higher costs related to the Granite Mountain Hotshots tragedy.  Excluding overtime and other non-base pay items would save Prescott 55 to 63 cents for every dollar spent on non-base pay.  This would also reduce pension costs long-term by lowering final average salary calculations made on employee pensions.  Employees would also get to keep the 11.65% employee contribution on non-base pay, instead of paying it into PSPRS.

I believe that Prescott voters knew intuitively that the budget savings freed up by the PSPRS sales tax would soon make its way back into the very same cost drivers that created the deficit in the first place, and they would be worse off than before the tax was implemented.  The Prescott political class expects taxpayers to act "responsibly" and pony up their hard-earned money to pay off the PSPRS deficit, but  they conveniently forget that it was politicians like them and their public employee allies who irresponsibly created this mess in the first place.  I think that the voters would agree to a PSPRS tax, just like the roads tax, if it was clearly tied to a pension cost control program.  Perhaps the political class will show some leadership this time around, instead of haranguing voters, by implementing some real reforms going forward.  If not, they shouldn't be surprised that voters don't trust them to do what's right with their money.

Wednesday, August 12, 2015

Cold feet in Canada? - An intriguing bit of information about PSPRS Administrator-select Kevin Olineck from the August 13, 2015 Board of Trustees special meeting

The PSPRS Board of Trustees had a special meeting today with the only business listed on the agenda as this:
Discussion of possible Action regarding selection of a job search firm to conduct a national search for a PSPRS Administrator.
The June 17, 2015 Board of Trustees regular meeting agenda included this routine-seeming piece of business listed as agenda item 25:
Update, discussion and possible Action on the System Administrator position and other personnel matters.
So obviously something seems to have changed in the last two months, so I looked back into the May 27, 2015 meeting minutes, which includes this bombshell:
The visa process was not successful and as per the agreement with the candidate, the offer will be withdrawn on either June 14 or 15, 2015.  The Administrator Selection Committee will reestablish itself to move forward.
So it now appears that Kevin Olineck will not be the new PSPRS Administrator.  It seems odd that a Canadian pension fund manager fulfilling a professional commitment could not get a visa to work in the United States, especially with the lax immigration policy of the current administration.   I suppose it could be this simple, as implausible as it may be, or maybe the British Columbia Pension Corporation offered him more money to stay.  Of course there is also the chance that as he learned more about the PSPRS and the Administrator job, the less attractive it became to him.

Tuesday, August 11, 2015

PSPRS' problems in a nutshell: Tempe's pension spiking deal with firefighters

Whenever there is a glimmer of hope that fair, sensible, and lasting pension reform can be accomplished, we get a reminder of  how PSPRS got into its current mess in the first place.  Exhibit A is the recent news that the City of Tempe is going to reclassify payments for sick and vacation leave sellback in a way to make them pensionable again, in order to skirt state law that excludes these payments from pensionable income .  The Arizona Republic has this August 4, 2015 story, and two opposing editorials Tempe pension gimmick sticks it to taxpayers by the Arizona Republic editors and Performance pay is not 'pension spiking' by Don Jongewaard, president of the Tempe Fire Fighters union, appeared on August 4 and August 9, 2015, respectively.

Up until recently, some employers did allow payments for unused sick and vacation leave to be included in pension calculations, despite a state law that clearly prohibited it.  The relevant Arizona statute reads:

"Compensation" means, for the purpose of computing retirement benefits, base salary, overtime pay, shift differential pay, military differential wage pay, compensatory time used by an employee in lieu of overtime not otherwise paid by an employer and holiday pay paid to an employee by the employer on a regular monthly, semimonthly or biweekly payroll basis and longevity pay paid to an employee at least every six months for which contributions are made to the system pursuant to section 38-843, subsection D. Compensation does not include, for the purpose of computing retirement benefits, payment for unused sick leave, payment in lieu of vacation, payment for unused compensatory time or payment for any fringe benefits. (Italics mine)
This practice allowed employees to save up their leave (mostly sick leave) over many years and received payments for it during their high-three years when their final pension was calculated.  This is pension spiking in its clearest form, where an employee's salary is artificially inflated during the years on which his final pension is based.  For example, an employee who sells back $5,000 a year in sick leave during his high-three years will raise his annual pension by over $200 a month, if he retires at 20 years (50% of average high-three salary for those hired before 2012).   The employee will pay about $1,747 (11.65% of $15,000) total over the three years, which he will recoup in his first nine months of retirement.  The City of Tempe has a non-phased-in contribution rate of just under 50% for the current fiscal year, so taxpayers will pay a total of about $7,500 in contributions at the current rate.  This blog has covered pension spiking in other posts, so I will not go further into the math, but it is important to remember how critical it is for contributions to compound over time.  End-of-career increases in pensionable salary, whether through leave sellback, overtime, or other enhancements, are the death by a thousand cuts that plagues PSPRS.

Fortunately, the Goldwater Institute successfully sued to stop this practice, and Phoenix and Tucson now prohibit it.  This should have been the end of this problem.  But not so fast.  The powers that be in the Tempe City Council and local firefighter union have thought up a method by which they can continue to slowly destroy their pension system and (hopefully) stay within the law.  Instead of receiving payments for leave already earned, employees with at least 17 years service would no longer accrue leave and receive the value of that foregone leave in the form of "medical and vacation performance pay" instead.  The tortured logic behind this plan is that since no previously accrued "unused" leave is actually being "sold" it is legal, although common sense tells us that employees are simply being paid for current leave that they would have earned and not used.  I do not see how this would not still be illegal.

This is not to say that there is anything wrong with selling back leave, only that it should not be pensionable.  I do not know if all, but many public safety agencies, have a requirement known as constant staffing, which means that all uniformed positions must be filled at all times.  This means that employees on sick or vacation leave must be always be covered by another uniformed employee.  This requires the payment of overtime to off-duty personnel if enough employees are absent, and discouraging leave use, particularly sick leave, saves employers money.  In his editorial, Mr. Jongewaard, the Tempe Fire Fighters union president, makes this point as well.  This is great since this is something that many taxpayers may not know about public safety work.

However, Mr. Jongewaard does not make a case for why payments for unused leave should be pensionable.  Employees will still receive the future pay incentive for limiting their use of sick leave, regardless of whether the payments are pensionable.  Employees still sell back sick leave where I work, even though it is no longer considered pensionable, because the financial incentive is attractive enough.  Even more telling is his lack of an explanation as to why a sick and vacation leave sellback program  needs to be contorted into a "medical and vacation performance pay" program.   It is obvious why.  It is an attempt to violate state law that specifically forbids this practice.  If you still doubt that this program in Tempe is pension spiking, look at the threshold for the program, 17 years.  It seems like a strange time to start the program--why not 15 or 20 years?  Where I work the amount of sick leave you can sell back increases at the following intervals: 5 years, 10 years, 17 years, and 22 years.  The reason for this unusual pattern of  increases is apparent when when we think of pension calculations.  Those hired before 2012 can retire at 50% of their average high-three year salary at 20 years service and at 62.5% of their average high three-year salary after 25 years service.  Is it a coincidence that the last two thresholds just happen to begin within three years of 20 and 25 years?  Of course not.

The more militant folks out there, who do not care at all about the taxpayer, may applaud Mr. Jongewaard and the union for cleverly extracting this benefit from the Tempe City Council, as after all, this is what a union is supposed to do.  True, however, is it really beneficial when you negotiate for a policy that will continue to bleed your own pension and divert scant department budget from current wages and benefits?  Also, does this benefit all Tempe firefighters?  Those hired in 2012 or later already have to work longer, pay more, and receive fewer benefits from PSPRS.  I have made the point before that unions act less as a collective working for all members and more like a seniority protection organization.  This seems to be the case here.  Those like Mr. Jongewaard, who states he has over 21 years of service, will certainly benefit from this pension spiking scheme, but this is not the case for someone just starting a career.  Newer firefighters and those who join the department in the future will see their wages impacted for the rest of their careers because their employer will have to plow more money into an underfunded PSPRS in order to pay the spiked benefits of those who retired decades before.  Passing the costs of one generation's excess on to future generations is hardly fraternal behavior.

Missing here is the perspective of the Tempe City Council.  The firefighter union at least can make a case for this policy out of naked, if misguided, self-interest.  What of the Tempe City Council?  They got nothing of value out of this for taxpayers, just higher pension contributions and a future lawsuit they will have to fight.  Now would be the time cue the conspiracy theorists, but unfortunately, I think
this is just business as usual in a world of other people's money and explains a lot about PSPRS' current woes.  If this is what the Tempe City Council will do when PSPRS is dangerously underfunded, what would they give up in good financial times?

Saturday, August 8, 2015

How PSPRS digs itself deeper into a hole without even trying

For me the math and methodologies involved in pension accounting get so complicated and arcane, that it seems more like art than science so I am grateful whenever I see something that provides a simple explanation of a pension accounting concept.  An example is this small piece, David Crane explains the ramifications of CalPERS' 2.4% return for the past year, that appeared on the Pension Tsunami website.  In it, Mr. Crane's explains how an underfunded pension, like PSPRS, is in much worse shape than it appears at first glance:
Recently newspapers have reported that CalPERS earned 2.4% over the last twelve months and contrasted that return with its 7.5% assumed rate of return. But what those newspapers have not reported is that CalPERS needs to earn much more than 7.5% per annum for its unfunded liability not to grow.
This is because (i) under US public pension fund accounting, liabilities grow at the assumed rate of return and (ii) currently, liabilities exceed assets. That means assets have to grow faster than the assumed rate of return in order to keep up with liabilities.
As a simplified example, let’s say a public pension fund has a 77% funding ratio, which means that it has assets equal to 77% of liabilities. For greater simplicity, let’s say it has assets of $77 and liabilities of $100, and therefore an unfunded liability of $23 (100-77). Because of item (i) above, liabilities grow 7.5% per annum. That means liabilities that today equal $100 will in one year equal $107.50. For the unfunded liability not to be larger than $23 at that time, that means assets have to grow from $77 to $84.50 (107.50-84.50 = 23). That means that the pension fund needs to earn 9.7% ($77 times 1.097 = 84.50). Anything less and the unfunded liability will grow.
This is why it’s so hard for US public pension funds to catch up once they fall behind. See this relevant article from The Economist.
If we use Mr. Crane's same calculations, how much does PSPRS, which was only funded at 50.4% on June 30, 2014, need to earn in a year to keep its unfunced liability from growing?  At the 50.4% funded ratio (assets divided by liabilities), PSPRS has only $50.40 in assets to pay off the $100.00 it owes to its members, leaving an unfunded liability of $49.60.  The $100.00 liability will grow the next year to $107.85 at its current expected rate of return (ERR) of 7.85%.  In order for the unfunded liability to stay at $49.60, PSPRS' assets would need to grow from $50.40 to $58.25 (107.85-58.25 = 49.60), which translates to an annual interest rate of 15.56% (50.40*1.1557 = 58.25).

If PSPRS were to earn the 7.85%, the 50.4% funded ratio would not change since both its assets and its liability would go up proportionately, but the actual dollar amount of the unfunded portion would increase from $49.60 to $53.49 [the new assets would be (50.40*1.0785 = 54.36) and the new unfunded amount would be (107.85-54.36 = 53.49)].  We can see why returns that exceed the ERR are so important when you have a deficit.

It appears that PSPRS will not reach its ERR for the 2015 fiscal year that just ended.  I estimate that PSPRS will earn somewhere between 4.5% and 5.0%.  If PSPRS earned only 5.0% in the last fiscal year, its liability will again grow to $107.85, but its assets will only grow to $52.92.  This will mean that its unfunded portion will grow from $49.60 to $54.93, and the funded ratio will only be 49.07%, a decrease of 1.33%. 

This is an oversimplification of how PSPRS calculates its funded ratio because PSPRS uses a seven-year smoothing period to spread out gains and losses more evenly.  If we do not factor in the negative effects of the Hall lawsuit and a lowering of the ERR to 7.5%, PSPRS should actually see a positive movement in its funded ratio over the next two years because the extraordinarily large losses incurred during the Great Recession should fall out of the seven-year smoothing period.  Regardless, Mr. Crane's calculations are still very enlightening as to how critical market returns are to an underfunded pension.

The interesting thing to look at here is how COLA's or permanent benefit increases (PBI) under the excess earnings model affect the funded ratio.  Remember that at the current funded ratio of 50.4%, PSPRS would need to earn 15.56% to keep its total unfunded liability from increasing.  Remember also that with the excess earning model, PSPRS must pay half of any earnings over 9.0% into a special fund that can only be used to pay COLA's.  This means that PSPRS would actually have to earn a whopping 22.12% in order for its liability to remain the same.  The 6.56% over the 9.0% COLA threshold would need to be doubled in order to maintain the 15.56% rate since half of anything over 9.0% would be placed in the COLA fund.

If PSPRS actually did earn the 15.56% in a year, its unfunded liability would still grow because 3.28% of the gain over 9.0% would go into the COLA fund.  Using our earlier numbers, the liability would still grow from $100 to $107.85.  However, the assets would grow from $50.40 to $56.59 (50.40*1.1228), and $1.65 (50.40*0.0328) would go into the COLA fund.  This means that the original unfunded liability would increase about $1.65 from $49.60 to $51.26 (107.85-56.59).  So even if PSPRS earns 15.56% its unfunded liability will still grow larger when the excess earnings COLA model is in place.

Now if we multiply the figures we have been using by $100 million to bring them more in line with PSPRS' actual assets and liabilities, we can see how much money we are actually talking about.  A
$4.96 billion unfunded liability would grow by about $165 million to $5.126 billion, despite the fact that PSPRS earned an outstanding 15.56% return on its investments.  The other $165 million would be used to pay a COLA of up to 4% of the average normal retirement, which would increase the total liability and further widen the gap between assets and liabilities.  This is exactly what you don't want to happen when you are already in the hole.