Friday, July 17, 2015

Here's the good news and bad news if you're a PSPRS retiree expecting a COLA

Normally around this time every month, we can see the monthly returns for PSPRS.  Unfortunately, the PSPRS Board of Trustees is not having a July meeting this year, so I have no PSPRS month end returns to post for May 2015.  The following table has updated monthly returns from the Russell 3000 and estimates for the YTD returns for May and June 2015:

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    ?    ? 1.38% 9.01% (est)
6/30/2015    ?    ? -1.67% 7.34% (est)

As can be seen, the Russell 3000 will have a 12-month return of around 7.30%.  While far removed from the 25.22% the returned last year by the Russell 3000, this is still a good return.  However, we are in the pension world here, so we have to look at two particular PSPRS benchmarks: the expected (or assumed) rate of return (ERR) of 7.85% and the permanent benefit increase (PBI) threshold (aka COLA) of 9.00%.

It is unlikely that PSPRS will reach either benchmark this fiscal year.  PSPRS would have to average about 1.75% for each of the last two months to reach 7.85% for the year.  This is important since not meeting your ERR is, for pension accounting purposes, a negative return and increases your liabilities.  Over a long period this is not a big deal since you will likely make it up in another year like last fiscal year, but PSPRS is already in deficit.  This will add more hardship to employers already struggling to pay their annual required contributions.  There is a remote chance that PSPRS could reach its ERR since it did surpass the Russell 3000's returns by 2.35% over the past two months, but I would still consider this very doubtful, especially when we consider that we must subtract half a percentage point from the final PSPRS returns to cover investment fees.  This would mean that PSPRS would actually have to earn about 2% each month to get to 7.85%.

Obviously, if PSPRS has only a remote chance to reach 7.85%, 9.00% will be impossible. PSPRS would have to earn over 5% in the last two months to get to 9.00%, considering investment fees, and barring a miracle, this ain't going to happen.  This means that PBI's will not be paid for the current fiscal year since, according to PSPRS, the PBI fund was depleted last year, and the failure to meet the 9.00% threshold will not allow any replenishment of the PBI fund this year.  That is the bad news if you are a retiree.

The good news is that for the 12-month period ending June 30, 2015 there was almost no inflation, according to the Bureau of Labor Statistics.  The inflation numbers can be found at the U.S. Inflation Calculator.  The past fiscal year inflation rate was 0.1%, meaning something that cost $100.00 on June 30, 2014 would cost only ten cents more a year later.  The 0.1% annual rate compares with a 2.1% inflation rate the year before.  Of course, your bills may tell a different story about how much things cost versus a year ago, but that's what the Consumer Price Index says.  Anyway, PSPRS, like the Cubs, always has next year.

Tuesday, July 14, 2015

What the Hall is going on? Legal issues surrounding the Hall and Parker cases against EORP and PSPRS

From this July, 13, 2015 Arizona Republic article by Craig Harris, Arizona Supreme Court picks five judges to hear pension case, we can now see that we will most likely have a final decision on the Hall case sometime next year, as the article states that the case will be heard before the end of 2015.  The actual decision may take longer, for if we look at the Fields case, it was argued before the Arizona Supreme Court on June 4, 2013, but the decision was not released until February 20, 2014, a lag of over eight months.  The interesting thing with the Hall case is that, in order to avoid a conflict of interest, the Arizona Supreme Court has appointed five judges who have no stake in the decision, as the five are under the new EORP system.  Hopefully, this specially appointed panel will mean that the case is decided more quickly since this is the only case on the panel's docket, though the judges will still have to deal with their regular assigned caseloads.  Regardless, this is a good time to talk about the legal issues surrounding Hall.

If you were an active member of PSPRS prior to July 2011, the Hall v. Elected Officials' Retirement Plan (EORP) case has huge significance for you.  Unlike Kenneth Fields, a retired judge who successfully sued EORP over SB 1609's change to COLA calculations for retirees, Philip Hall (who, according to Ballotpedia, retired in 2013) was an active judge at the time SB 1609 went into effect.  He, like the plaintiff in Parker v. PSPRS, an active law enforcement officer when SB 1609 went into effect, is suing over both SB 1609's change to COLA calculations for retirees and the increase in employee contribution rates.  Mr. Hall was successful in Maricopa Superior Court, and a final decision was rendered in January 2015.  The result in Hall, which has moved up to the Arizona Supreme Court, will determine the result for PSPRS members as well.  If Mr. Hall's case is fully or partially upheld by the Supreme Court, it would have enormous financial consequences for all PSPRS members.

A good explanation about the court cases involving PSPRS and EORP can be found at the Pension Litigation Tracker website run by the Laura and John Arnold Foundation.  This website gives a great timeline of all the events in both Fields and Hall, and the legal precedents for the decisions as of now.  If you are like me, you probably just want to know if Mr. Hall's case is going to be upheld on appeal.  This will determine how your future retirement COLA's are calculated, and in the near term, whether you will be a due a refund of your excess employee contributions and what your future contribution rate will be (7.65%, 11.65%, or another amount).  If Mr Hall is successful and, for example, you made $60,000 of pensionable income per year in the five fiscal year between July1, 2011 to June 30, 2016, you would be owed a refund of excess contributions of  $7,800 ($600 + $1,140 + $1,620 + $2,040 + $2,400) due to the annually increasing employee contribution rates (1.0%, 1.9%, 2.7%, 3.4%, and 4.0%) during those years.  Of course, it is impossible to know what the final decision will be since it all comes down to the five members of the Arizona Supreme Court-appointed panel, but the information provided gives some interesting points to discuss.

We should start off by saying that Mr. Hall seems likely to win his case (with a key caveat that we will talk about later) on SB 1609's changes to the COLA formulation for the same reason that Mr. Fields won.  Per Pension Litigation Tracker, there are three main constitutional issues in Hall and Fields:
  1. The Contracts Clause in Article II, §25 of the Arizona Constitution which states, "No bill of attainder, ex-post-facto law, or law impairing the obligations of a contract, shall ever be enacted."
  2. The Pension Protection Clause in Article XXIX, §1(C) of the Arizona Constitution which states, "Membership in a public retirement system is a contractual relationship that is subject to Article II, §25, and public retirement system benefits shall not be diminished or impaired.”
  3. The Yeazell v. Copins (1965) Arizona Supreme Court decision, "which held that a public employee’s interest in his retirement pension is a contractual one that vests at the outset of employment; and, the employee has a vested right to continued membership in the retirement pension plan 'under the same rules and regulations existing at the time of his employment.'"
You can read the full Fields decision here, but the Pension Clause was the main justification for deciding in Mr. Fields' favor.  The Court held that the COLA was a "benefit" as commonly understood and was in place at the time of Mr. Fields' retirement, so it could not "diminished or impaired."  The defendants argued that since there are conditions under which the Contracts Clause can be violated and the Pension Clause references the Contracts Clause it was permissible to impair and diminish benefits in certain cases.  The Court dismissed this by concluding that the Pension Clause actually gave extra and specific protection to pension benefits, otherwise there would have been no reason to add it to the Constitution.

This was a slam dunk for Mr. Fields, but the Hall case gets much more interesting for all of us who were active PSPRS members when SB 1609 went into effect if we consider two issues that the retired Mr. Fields did not have to worry about: vesting statutes and the increase in employee contribution rates.

The Hall case has raised the issue of when an EORP member fully vests.  Maricopa County Superior Court Judge Douglas Rayes initially ruled in favor of Mr. Hall, declaring both the original COLA formulation and lower contribution rates were pension benefits that could not be "diminished or impaired," but he excluded from this decision anyone hired after 2000, citing the 2000 EORP vesting statute which states that EORP members do not fully vest until they apply for benefits.  Judge Rayes later reconsidered this decision and concluded that it applied to all EORP members, regardless of when they joined EORP.

This is interesting because it shows a small crack in the wall that protects pension benefits, particularly for PSPRS members.  In March 2013, this judge initially agreed with EORP's contention that the vesting statue was "part of any contractual relationship created when post-2000 EORP members began their employment," and "it is clear under Yeazell that the terms of an employee's contract incorporate the statutes on the books at the time."  He reconsidered this decision in July 2013 and better clarified exactly what "vesting" means.  However, Judge Rayes, who seemed fairly sympathetic to the plaintiff's case, did initially find this common ground with the defendants.  Both EORP and CORP, the corrections officers' plan, having vesting statutes that date back to only 2000.  PSPRS's vesting statute dates all the way back to 1983!  Does this carry more weight since it goes back further?  Is there some precedent between 1983 and 2000 in which the vesting statue was used to impair benefits that could be used to justify impairing them now?  We will have to see, but this is the caveat I mentioned earlier that could affect PSPRS members if the panel interprets the PSPRS vesting statute as Judge Rayes initially did.  It could mean that the change in the COLA formulation could be found to be constitutional for the overwhelming majority of us.

The second issue of employee contribution rates is even more interesting.  In his March 2013 judgement, Judge Rayes states, "Plaintiffs argue that the 1998 Formula and 7% contribution rate are 'public retirement system benefits'.  The Court agrees.  Although Plaintiffs are not entitled to receive their retirement benefits until they are employed the required number of years, they are nevertheless legally vested in the formula under which their benefits are calculated."  The defendants argued that "the contribution rate is the price paid by the employee for the benefit, not the benefit itself."  On a common sense reading, the defendants seem to have the more compelling argument since the contribution rate has no bearing on the calculation of the benefit.  Retirees will still have their retirement calculated the same way and receive the same COLA, regardless of how much they are required to pay into the system.  This seems to stretch the Pension Clause way beyond its intent.

While Mr. Hall's lawyers also cited the Contract Clause and the Judicial Salary Clause, which prohibits decreases in a judge's salary during his term in office, to bolster his case, the precedent of Yeazell seems to make the strongest argument for the plaintiffs since it states that one is vested "under the same rules and regulations existing at the time of employment."  Yet all the past cases cited involve the conditions under which an employee can retire and how their post-employment benefits are calculated.  The cited cases all seem to involve a legislative change after someone joined the retirement system that alters the conditions of retirement or the calculation of post-employment benefits, not how much they paid for the benefits.  None of the cited cases seem to deal with an increase in the contribution rates of active employees, though Judge Rayes considered the contribution rate as a component of "retirement benefits," so this may be a new issue for the panel to decide. Do employees legally "vest" in the contribution rate that existed when they were hired?  Are contribution rates, or rather the lost income caused by increase over the initial rate, a "benefit" as opposed to a cost not unlike health insurance?

In its argument in Fields, EORP states this was not so.  They cited the 1992 case of Smith v. City of Phoenix, in which a city judge argued unsuccessfully that the salary structure under which he was hired, which by city statute kept his salary at 95% of superior court judges, was an enforceable contractual agreement.  The city changed the statute to hold city judges at their existing salary in advance of a pay raise for superior court judges, and Smith sued.  The Fields opinion says, "The court of appeals held that Smith had no contractual right to continued salary increases under the city ordinance, observing that his 'contract of employment' did not express 'that the method of calculating his salary would remain fixed throughout his term,'  and '[i]ndeed the fact that both parties knew his salary was established by a city ordinance, which was naturally subject to change by the city council, suggests just the opposite.'"  The Arizona Supreme Court dismissed the Smith case as irrelevant to Fields and wrote:
Assuming the case was correctly decided, we note that it reflects the general principle that statutory provisions do not create contractual rights . . .  But statutorily established retirement benefits are an exception to this rule . . . Under Yeazell, the right to a public pension on the terms promised vests upon acceptance of employment . . .  and "the State may not impair or abrogate that contract without offering consideration and obtaining consent of the employee
Mr. Fields was already retired when he sued EORP so the question of increased employee contributions was not germane to his case, yet EORP's use of Smith to bolster its case was interesting and seems likely to reappear when Hall is argued, where it would seem to be much more relevant.  All these statements are all very intriguing:
  • the method of calculating his salary would not be fixed throughout his term
  • assuming the case was correctly decided
  • statutory provisions do not create contractual rights
  • statutorily established retirement benefits are an exception to this rule
Yet we are still stuck without a definitive explanation as to if and how pension contribution rates fit under the umbrella of pension "benefits."  Only the opinions of those five judges matter.

Looking to other states that have tried to raise pension contribution rates, the general impression is favorable to do this legislatively, though among states with constitutional public pension protections, only the Michigan Supreme Court has so far upheld increases to existing employees' contribution rates.  Many of the cases are still being litigated, and others are being contested over different constitutional provisions.  Completed Supreme Court cases in Florida, Alabama, and New Hampshire all held that plaintiffs had no right to a fixed contribution rate, and for what its worth, the New Hampshire Supreme Court in its December 2014 decision cited the cases in Florida, Alabama, and Michigan as precedent.  Once again, we will have to see what those five judges think.

All this would seem to argue for the repeal of Article XXIX 1(C) of the Arizona Constitution so that public pension benefits do not get any extraordinary protection beyond any other contract.  Any pension "reform" that is financially adverse to a pension system member is a violation of Article II based on the precedent set in Yeazell.  Financially adverse pension reform is reneging on a contract established when the employee entered the pension system on hiring.  This was the case in 2011 with SB 1069 as it is now the case with the Professional Fire Fighters of Arizona's (PFFA) Operation Blue Falcon.  Under Article II and Yeazell, the PFFA's proposal is just as unconstitutional as SB 1609, if not in letter, certainly in spirit.  Furthermore, the PFFA "fix" is harmful to its own constituents and a worse plan than SB 1609.

Article XXIX 1(C) essentially makes pension reform impossible.  Even the PFFA's ridiculous proposal to amend Article XXIX via voter referendum will almost certainly face legal challenges under Article II and Yeazell.  The easiest thing to do is repeal Article XXIX 1(C) and allow the legislature to make reforms with input from all stakeholders, and we must accept that in probably every case there will be a lawsuit.  But without the special legal protections of Article XXIX 1(C), there might be a chance to get some reforms through that could incrementally fix the pension instead of dangerously trying to legislate via constitutional amendment.  The PFFA stated in 2011 that "No fix is needed for police, fire pension." Yet look where they are now.  The same lack of foresight they had back then infects them now.  If the PFFA sets a precedent now and "reforms" PSPRS by amending Article XXIX 1(C) and overriding Article II and Yeazell, what will stop some other group, perhaps one less friendly to public safety personnel, from amending it again in the future in a way that even the PFFA will not like.

Just something to think about, but regardless, we should all have a very interesting year ahead of us.  Stay tuned.

Tuesday, June 30, 2015

The League of Arizona Cities and Towns Pension Task Force's plan for PSPRS: Several good ideas and one big problem

With all the discussion about the Professional Fire Fighters of Arizona's (PFFA) bad PSPRS pension reform plan, it is easy to miss another plan that is being developed by the League of Arizona Cities and Towns Pension Task Force ("the Task Force").  The preliminary Task Force Plan is available at their website, but a more thorough explanation is available on PDF pages 7-33 of the PSPRS Board of Trustees May 27, 2015 meeting materials.

I was particularly critical of the recommendations the Task Force put forth in the PSPRS employer seminars held this past spring, so let me start off by saying that, unlike those recommendations made to employers, this plan has much more to it and should be taken seriously, despite a major (and very likely fatal) flaw we will discuss later.

Here are the major points of the Task Force's plan:
  1. No transition to a defined contribution plan.
  2. Creating a new public safety pension system for those hired after some future date.
  3. Maintaining the current PSPRS benefit structure for retirees and workers hired before that future date until all have passed away.
  4. Pooling assets and liabilities.
  5. Fully funded status (100%) at all times.
  6. Equal cost sharing between employers and employees.
  7. Benefit increases paid through increases in contributions.
  8. True COLA's to keep retirees equal with inflation.
  9. Mandatory participation in an employer-matched defined contribution plan as supplement to retirement income, in lieu of Social Security.
  10. Changes to the governing structure of the new public safety pension, including the elimination of local boards and a different makeup of the Board of Trustees.
Let's start with the good parts of the Task Force's plan:

Point Number One:  The real good news is point number one, which is that the Task Force is not recommending a transition to a defined contribution retirement plan, like what happened to the Elected Officials' Retirement Plan (EORP).  However, this is not surprising since I am guessing that most of the Task Force are members of the Arizona State Retirement System (ASRS), and it would have been hypocritical for them to recommend the elimination of a defined benefit pension for someone else while they kept their own.

Point Number Six:  Their participation in ASRS likely influenced point number six, which is another good idea.  As ASRS members, they are on the hook for half of any annual contribution increases in their system, and that a system of shared sacrifice should be included in any new public safety pension system.  With a fixed employee contribution rate and an unlimited employer contribution rate, PSPRS is grossly unfair to taxpayers.  Also, no one can deny that ASRS is in much better financial shape than PSPRS, and I would argue that equal contributions are one of the reasons why.  As was discussed here, equal contribution levels show active employees the real financial health of PSPRS and allow for gradual changes in contribution rates to deal with problems before they get too big.

Point Number Seven:  Along the same lines is point number seven, which allows the cost of any benefit enhancement to be paid only through increases in contributions.  The fiction that you can rely on stellar market returns to enhance benefits has been blown to bits.  Requiring the prefunding of any benefit enhancement places the burden on those who will receive the benefit, not on future employees and taxpayers who are not around to object but will still have to pay for it.  A sustained bull market and an overfunded pension, no matter how permanent they may seem at the time, will no longer be an excuse to enhance benefits out of thin air.  We know now how transient an overfunded pension can be and that what goes up can always come back down.  So point number seven is another good idea.

Point Number Five:  Speaking of fictions, we can look at another good idea in point number eight.  You would think that the idea that a pension system is healthy at anything less than 100% funded would be viewed as nonsense.  Somehow, though, like some type of urban legend, it has become common to refer to a pension that is 80% funded as "healthy."  I am not sure why this is, but my limited knowledge of pension accounting includes the concept of a "collar," which I gather is a range that a pension's funding level can move, without undue concern, due to market, demographic, and other fluctuations.  That range seems to run between 80-120%, and one should not be concerned if your pension runs down into the 80's or up into the 110's as this is to be expected from time to time.  This would be fine, except the concept seems to have been corrupted.  Instead of the range being accepted as a area within which a pension could float up and down, the 80% appears to have become the benchmark of a "healthy" pension.  I suspect this is how PSPRS ended up with a financially unsound program like the DROP, which was developed in the late 1990's/early 2000's when PSPRS was briefly over 100% funded.  Instead of accepting the >100% status as a normal fluctuation that would be offset later by a future period of <100% funding, a program was devised to take that "excess money" sitting there.  We all know what has happened since then.  By setting a goal of 100% funding at all times, this type of problem should not happen again by making it clear where the pension should be at all times.

Point Number Eight:  Point number eight is probably the best idea the Task Force has put forward, though it is the most obvious: attempt to keep retirees even with inflation.  The fetish for formulas that determine cost of living allowances (COLA's) or permanent benefit increases (PBI's) comes from a desire to lock in an amount that cannot be changed later.  To that point, we end up with the shortsighted and harmful excess earnings formula we have now or the PFFA's destined-to-fail attempt to replace it.  The problem with both is that neither has any relation to inflation, the real increase in the cost of goods that retirees must pay when they no longer have the ability to work.  The excess earnings formula is great until inflation increases above 4% per year, then those who fought so hard to keep it will complain that they are slowly being robbed of the full value of their retirement.  This will be especially true as PSPRS throttles back its expected rate of return and/or becomes more conservative in its investments and the 9% threshold is rarely, if ever, exceeded.  (The PFFA wants to limit retirees to only a maximum of 2% per year.)  The goal of any COLA/PBI policy should be to maintain purchasing power throughout retirement.  This can only be done with a decision made on an annual basis.  Will this method always meet the level of inflation?  I don't know, but it will be more flexible than what we currently have or what is being proposed by the PFFA. 

Point Number Nine:  There is not too much to say about this point.  If employers are willing to match employees' contributions into a defined contribution plan, I say, "Where do we sign up?"

So those were the good points of the Task Force's plan.  Here are two that are difficult to say whether they are good or bad without greater detail:

Point Number Four:  I am not sure how the pooling of assets and liabilities will work.  As it stands right now, employers' assets are pooled, and all are placed in the same investments and all share proportionally in profits and losses on that pool of investments.  However, each employer has its assets and liabilities accounted for separately, and its contribution rates are assigned according to how closely their assets match the liabilities each owes to current and retired employees.  The Task Force plan appears to want to truly pool assets and liabilities in the sense that a single contribution rate for all employers that is calculated each year based on the total assets and total liabilities of the entire system, then split it 50/50 between employers and employees.  The Task Force even uses the example of the City of Prescott, which is struggling with an enormous unfunded PSPRS liability and is asking voters to raise the sales tax to help fund it, to make its point.  However, when we look at the huge disparity in employer contribution rates throughout PSPRS, is it fair to expect taxpayers in another area to make up for the errors of others throughout the state?

For the most part I would say "no."  However, Prescott is a strong example of a "yes" case since they were hit with the deaths of the nineteen Granite Mountain Hotshots.  While I believe that only nine of those lost, including the three retroactively placed into PSPRS, were eligible for PSPRS pensions, we have to remember the small size of the Prescott Fire Department, which their website says has 92 members.  These nine firefighters represent nearly ten percent of their department.  To put this in perspective this would be like the City of Tucson losing 60 firefighters or DPS losing 100 officers in one day.  Line of duty death pensions are 100% of the lost member's pensionable salary, so you can see why the pooling of liabilities would be a good thing in a case like Prescott's.

Fortunately, this is a rare case and, hopefully, will never happen again.  The problem I see will be when it comes to pension spiking.  Unless the Task Force's plan limits pensionable salary to base pay, what will stop one employer from allowing its employees to work more overtime than other employers' employees and pass the cost of the spiked pensions on to everyone else?  This is where the natural human impulse to work the system for maximum personal gain will come into play.  At least now these costs stay with the employer who allowed it.  If assets and liabilities are truly pooled, these costs will be hidden in a contribution rate borne by all employers and employees.

Point Number Ten:  While the Task Force does not explicitly say it wants to eliminate local boards, the Task Force does make a point of saying that it would like "one independent disability committee of qualified experts."  The vast majority of local boards' business is a formality in which all the real work is done by the employers and PSPRS, then approved by the local boards, so eliminating their role in deciding the validity of disability claims would make their existence virtually pointless.  Does this mean that the Task Force believes that disability pensions are being improperly awarded?  I don't know without more information.

Finally, I am not sure what will change with the Board of Trustees.  The current Board seems qualified and made up of representatives of labor, government, and the public.  The ASRS Board has representatives of the public, educators, retirees, and political subdivisions.  The Task Force states it wants the Board to be made up of "independent, qualified experts with fiduciary responsibility of ensuring compliance with plan elements."  Does this mean that they think the current Board is not?  Once again, I do not know without more to go on.

So now we get to the parts of the Task Force's plan that are, while not necessarily bad, make no sense for the same reason their employer recommendations made no sense:

Points Two and Three:  The Task Force wants to create a new pension system for public safety personnel hired after some future date, and they want to leave the current system in place with no changes at all for those hired before that future date.  This is great!  Matter solved, but there is only one problem: HOW DO THEY PLAN TO PAY FOR IT?

Creating a new, better system would be fine, but the liabilities for the old PSPRS would remain and still need to be paid down.  Paying this down would have to be done with no new members joining the old system and with the paying membership dwindling each year as members of the old system retired or otherwise left the system.  The financial burden of employers would grow for years before finally heading downward when the number of retirees began to decrease.  EORP was able to transition to a defined contribution system for those hired after 2013 because its costs are lower due to its small membership (1,896 active and retired members as of June 30, 2014 versus 29,050 actives and retirees for PSPRS), and it also has the backing of the deeper-pocketed state treasury.  Maybe those PSPRS employers not carrying huge liabilities can implement the Task Force's plan, but for the most heavily indebted, the plan will be impossible.

I appreciate the fact that the Task Force is trying to cut the constitutional Gordian Knot by completely leaving the old system in place until all members pass away and simply creating a new system that will be free from legal challenges.  However, it does not resolve the central financial problem.  Do they have a creative way to finance the huge costs involved in the transition to a new pension system?  I hope so.  Otherwise, this plan amounts to another case of belling the cat.

It seems like it would have been easier to start with points two and three and end there, but I think that the Task Force did make several really good recommendations about pension reform that might be worth implementing in any future reform proposal.  I would like to thank the Pension Task Force for all their work, even though I think their plan is fatally flawed, but I would be happy to be proven wrong if they have a financial solution they have not yet told us about.

Wednesday, June 24, 2015

The downward spiral: PSPRS to drop its assumed rate of return to 7.50%; employer rate to go up 3%

For your consideration is the following correspondence from PSPRS Acting Administrator Jared Smout that appeared on PDF page 109 of the June 17, 2015 PSPRS Board of Trustees meeting materials:

From: Jared Smout
Sent: Thursday, June 11, 2015 9:30 PM
To: Jared Smout
Subject: Assumed Rate Discussion from May Meeting


I’ve been meaning to clarify some of the discussion surrounding the change in the assumed rate from 7.85% to 7.5% at the last meeting.  I apologize for any confusion caused by my attempts to explain the timing of this change to when it will be seen in the employer rates.

As it stands, the motion last month made the change to the assumed rate effective July 1, 2015.  This is obviously consistent with past practice and is necessary to set the interest rate for those in Tier 1 of the DROP for the next fiscal year.  However, also consistent with past practice, but not necessarily understood to be intentional, there will be a two-year lag before this change is reflected in the employer rates.  With the change in the assumed rate being effective July 1, 2015, past practice will dictate that this rate change will not be incorporated into the annual actuarial valuations until June 30, 2016, which means it will not be effective in the employer rates until July 1, 2017—ergo, the two‐year lag.

In my opinion, June 30 is only the snapshot for the data in order to perform the valuations and it doesn’t make sense to wait two years for the change in the assumed rate to become effective, thereby losing one year that could have a meaningful impact to the funding levels.  The sooner a change in an actuarial assumption can be implemented, the better, and our actuaries agree and support this approach.  Therefore, I believe the Board of Trustees can change this practice through a motion to allow any change in the assumed rate to be reflected in the annual actuarial valuations being performed during that fiscal year it is effective, regardless of the date of the data.

Another thing to consider is if the Hall case gets upheld on appeal, the earliest it would be reflected in the valuations would be as of June 30, 2016.  It is estimated the impact of the Hall case will have a 6 percentage point increase in the aggregate employer rate.  Additionally, it was shared last month that the change in this assumed rate will have a 3 percentage point increase in the aggregate employer rate. Therefore, if we continue with past practice as to the timing of the assumed rate being effective, the June 30, 2016 valuations (for July 1, 2017 implementation) could reflect the Hall case and the change in this rate, thereby causing a combined increase of 9 percentage points on the aggregate employer rate two years from now.  However, allowing the change in the assumed rate to be incorporated into the June 30, 2015 valuations (effective in the July 1, 2016 rates) could permit that extra year of increased  assets due to a lower assumed rate, which could help soften the adverse effects of Hall should it be upheld.

I just wanted to make sure everyone understood the timing and if there is any desire to discuss this further, I will agendize it for discussion and possible action.

Jared A. Smout
Acting Administrator

This is taken verbatim from the meeting notes with the exception of the boldface type in the fourth paragraph, which I added for emphasis.  Mr. Smout had previously discussed at the spring employer seminars the 6% increase in the aggregate employer rate that will occur if the Hall case is decided completely in the plaintiffs' favor.  However, the lowering of the assumed rate of return from 7.85% to 7.50% and its 3% increase to the aggregate employer rate is new information.  On PDF pages 106-108 of the May 2015 PSPRS Board of Trustees meeting materials is a letter from PSPRS' actuary, Gabriel Roeder Smith & Company (GRS), that explains the rationale for lowering the assumed rate.  Though I do not completely understand the methodology, what I can gather is that eight investment consultants gave estimates on PSPRS' expected returns, and from these estimates, a range between the geometric and arithmetic returns is produced.  Using this method, the current 7.85% assumed rate was essentially equal to the higher 7.84% average arithmetic estimate, while the average geometric average estimate was only 7.10%.  GRS recommended that PSPRS move to the new 7.50% assumed rate to bring it more into the middle range of the two estimates.

The aggregate employer rate, which represents PSPRS as a whole, for the current fiscal year (FY) is 32.54% and will increase to 41.37% in the FY that starts July 1, 2016.  Each individual employer has its own employer rate that can be higher or lower than the aggregate rate.  The large increase from FY 2014 to FY 2015 is due to the Fields case being finally settled by the Arizona Supreme Court in favor of the plaintiffs.

Since we have already seen the pain inflicted by the Fields case, I think most everyone is already braced for another financial hit in the near future from Hall.  Whether it is 6% or, perhaps, less in the case of an incomplete victory for the Hall plaintiffs, there will be some negative effect to PSPRS' funded ratio and employer contribution rates.  I think very few are ready for this new blow to PSPRS, employers' budgets, and workers' and retirees' income.  GRS informed PSPRS on May 22, 2015 about the recommended changes to its assumed rate, and the Board of Trustees needs to decide when to implement this new assumed rate.  Mr. Smout is recommending that it be implemented on July 1, 2015 so that the 3% increase to employer rates does not occur in the same year as the up-to-6% increase that will be necessary after the final resolution of the Hall case.  PSPRS does not have its next Board of Trustees meeting until August, so we may not know what they decide for a couple months.  Regardless, the one thing we can count on is that the downward spiral of PSPRS will continue.

Wednesday, June 17, 2015

PSPRS investment returns through April 2015

The following table shows PSPRS' investment returns, gross of fees*, versus the Russell 3000 for April 2015, the tenth 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%
3/31/2015 0.83% 3.42% -1.02% 7.15%
4/30/2015 0.95% 4.40% 0.45% 7.63%

There is usually about a two-month lag in PSPRS reporting its investment returns.  April 2015 was the second consecutive good month for PSPRS.  I should say extraordinarily good because, if you remember, PSPRS' investment strategy is designed to balance risk and return by sacrificing some gains when the market is up in order to limit losses when the market is down, so outperforming  the Russell 3000 when it has a positive month is very good and producing a gain when the Russell 3000 shows a loss is outstanding.  An analysis of PSPRS' recent performance vis-a-vis its stated strategy is here.  Overall, PSPRS more than doubled the monthly return of the Russell 3000.  PSPRS' April 2015 returns were helped enormously by its non-US equity portfolio, which had a monthly gain of 4.22%.  The non-US equity portfolio had been the biggest laggard for PSPRS this fiscal year, but after this month, it is no longer the worst performing asset class at -1.43%.  That honor belongs to the real assets class which has a fiscal YTD return of -1.95% and is the only other asset class with a negative return YTD.

The Russell 3000 shows a 1.38% gain for May 2015.  As of June 16, 2015, the Russell 3000 has a loss of -0.17.  With that big gain in May and the pattern of the past two months, do we dare have hope that PSPRS might actually reach its expected rate of return (ERR) of 7.85% by the end of June? Taking into account the 0.5% in fees that must be subtracted from final fiscal year returns (the net of fee returns), PSPRS would have to earn about 4% over the last two months of the fiscal year to achieve its ERR.  I would like to remain optimistic, but if PSPRS is consciously trying to hit a narrow sweet spot of  annual returns between 7.85% and 9.00% in order to avoid paying PBI's, instead trying to earn as much as possible, it seems unlikely.

* 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, June 15, 2015

A bad plan executed badly: The Professional Fire Fighters of Arizona's (PFFA) PSPRS pension reform plan

As the Professional Fire Fighters of Arizona's (PFFA) PSPRS pension reform "fix" continues along, we now have something a little more concrete to analyze in the form of the PSPRS pension reform draft bill, available at the PFFA website.   As of late, PFFA President Bryan Jeffries has been going around the state presenting a slideshow about the PFFA plan to employers and PSPRS members.  The version of the slideshow available at the PFFA website is here.  This slideshow has been altered from the initial slideshow the PFFA was presenting.  The older version, available at the League of Arizona Cities and Towns Pension Task Force ("the Task Force") website, is here under the 10-24-14 agenda, but you will need Powerpoint to read it.

As I have pointed out in multiple posts, the PFFA plan is shortsighted, unfair, and does not solve any of the root problems of PSPRS.  However, in this post I just want to go into the specifics of the PSPRS pension reform draft bill ("the draft bill").  The bill was drafted by Michele J. Hanigsberg, which the state government directory indicates is a member of the Arizona Legislative Council (ALC)-Legislative Services Wing.  The Arizona Legislative Council gives it function as the following :
The Council staff provide a variety of nonpartisan bill drafting, research, computer and other administrative services to all of the members of both houses of the Legislature.
 The ALC appears to be the body that does the actual grunt work of turning a proposal into a bill, and since this bill incorporates all the ideas of the PFFA plan and is linked from the PFFA website, it appears that this is the bill that the PFFA wants.  The devil, of course, is in the details, so let's see what the draft bill actually says and what it means for employers and PSPRS members.

This analysis of the draft bill had an inauspicious start when I first compared the two Powerpoint slideshows on the PFFA and the Task Force websites.  The older slideshow from October 2014 states the following about the new system for funding permanent benefit increases (PBI):
Employees only pay 4% into the PBI fund.
The underscoring of "employees only" is in the PFFA's slide.  Compare this to what is says in the slideshow on the PFFA website:
Employees pay 4% into the PBI fund.
No underscoring and the elimination of the "only" are slight changes, but they mean a great deal for employers and active PSPRS members, because this is what the draft bill states:
In addition to an employer's contributions to the fund pursuant to this subsection, each employer shall contribute an amount equal to one percent to its employees' compensation to the cost-of-living adjustment account maintained within the fund for future benefit adjustments for retirees and survivors pursuant to Section 38-856.02.
It is even worse than this because the draft bill also states that employers will have to continue to pay 1% into the PBI even after an employee enters the Inflation Protection Program, the rebranded Deferred Retirement Option Plan (DROP), of which we will talk more about later.  When looking at the wording of the draft bill, we can see how disingenuous the change in the wording between the two slides is.  A more forthright wording would be:
Employees pay 4% into the PBI fund, and employers pay 1% into the PBI fund.
This 1% extra cost to employers is in addition to an increase in the minimum employer contribution level from 8% to 10%, meaning that employers will now pay at least 11% of their employees' pensionable wages, instead of 8%.  This many not seem like a big deal for those employers who are already paying sky-high contribution rates, but it will be a huge cost for those employers who do not have big unfunded liabilities and are at or under the current 8% minimum.  Furthermore, the increase of the minimum employer contribution is permanent, regardless of the future funding status of PSPRS.

For retirees, there is a crucial provision in the draft bill that is not addressed in the Powerpoint slideshow.  In addition to the three-year freeze on all PBI's, seven-year or 60 year-old waiting period for PBI's, a 2% maximum PBI, and a 25% dispersal limit from the PBI fund, there is this:
The annual maximum percentage adjustment to the base benefit is the lesser of two percent or the percentage change published by the United States Bureau of Labor Statistics of the consumer price index for all urban consumers, using the United States city average, unadjusted, for all items, during the twelve months ending July of the year in which the benefit is to be paid.
While I am a strong advocate of an adequately funded PSPRS paying true cost of living adjustments (COLA) based on some measure of inflation, this is another case of an egregiously bad formula for PBI's.  This provision means that, regardless of the funding level of the PBI fund and/or the rate of inflation, retirees can only get a 2% maximum PBI per year, but in any year that the CPI is less than 2%, regardless of the funding level of the PBI fund, they could get less than 2% all the way down to nothing at all.  The same inexcusable lack of foresight that burdened us all with the current, unsustainable excess earnings PBI formula exists in this PBI provision.  Retirees can see one year of 5% inflation and receive a 2% PBI, but the next year see 0% inflation and get no PBI, despite the fact that they are still 3% behind in their purchasing power.  It this post you can see recent COLA's paid by Social Security.  The four-year period from 2009 to 2012 show two years of 0% inflation in 2010 and 2011 bookended by 5.8% and 3.6% inflation in 2009 and 2012, respectively.  Under this PBI provision, a retiree would have received 4% in PBI's against 9.4% inflation, leaving him a 5.4% difference.  (These percentage amounts are non-compounded for simplicity but would be worse if they were.)  If the PBI fund was adequately funded, a 2% PBI each year would have left him only a 1.4% difference.

The most blatant misrepresentation by the PFFA relates to the new Inflation Protection Program (IPP).  As stated earlier, the IPP is the new name for the DROP, the ill-conceived program born of PSPRS' brief period of overfunding during the late 1990's and early 2000's, that has garnered bad press because of the huge payouts received by some PSPRS retirees.  The Powerpoint slideshow on the PFFA website says the following about the IPP:
The DROP will become the Employee Self-Funded Inflation Protection Program.
  • Tier 1 (members with 20 or more years on the job as of 1/2015)
    • No contributions
    • Interest rate = assumed rate of return for PSPRS
  • Tier 2 (everyone else)
    • Contributions during the program period
    • Interest rate = minimum 2% or 7-year average of PSPRS investment returns (whichever is greater)
    • Return of member contributions
The statements about member contributions are expressly contradicted by the draft bill which states:
A member who elects to participate in the Inflation Protection Program shall make member contributions to the the fund and the separate cost-of-living adjustment account in an amount equal to the member contributions required pursuant to Section 38-843, Subsections E, F, and G.  Member contributions made pursuant to Section 38-843 during the Inflation Protection Program participation period are not eligible to be refunded to the member.
As the DROP stands now, PSPRS members with at least 20 years of service as of December 31, 2011 (aka Tier 1) pay no member contributions and receive a variable interest rate based on PSPRS' returns with a minimum of 2% per year.  Those who were PSPRS members as of December 31, 2011 but did not have 20 years of service (aka Tier 2) receive the same interest rate as Tier 1 members, but they continue to pay member contributions.  (The DROP is not available to those hired in 2012 or later.)  These member contributions are refunded when the member leaves the DROP along with 2% interest.  The PFFA slide about the IPP appears to copy these provisions, even though the draft bill is very clear that IPP participants will pay contributions, and these contributions will not be refunded to them.  The draft bill also does not categorize Tier 1 and Tier 2 employees.  Conditions are the same regardless of  when a member joined PSPRS, and all will be paid the variable interest rate with the 2% minimum.

An employee averaging $70,000 per year for the five years in the IPP would make over $40,000 (11.65% employee contribution rate) in member contributions to PSPRS, so we are talking a significant amount of money.  The PFFA is selling the IPP to active employees as if it were no different than the current DROP, even though it will cost them thousand of dollars.  The draft bill gives an end date on the DROP program of December 31, 2016, so active members may want to consider their financial options beforehand.  If this does get approved by the voters in 2016, you will have less than two months to decide if you want to participate in the DROP before it disappears forever.

Unlike Obamacare, we don't have to pass this draft bill in order to see what's in it.  I appreciate that the PFFA has posted the draft bill on their website, but I do not understand why their are selling their "fix" in a way with incomplete and, in at least one major way, blatantly incorrect information.  While I do not believe that they are deliberately trying to deceive anyone, the fact that they started this reform process without a fully formed plan as to what they wanted to do does not inspire confidence.  The PFFA presented its slideshow to the Task Force on October 24, 2014 and this bill was drafted on January 9, 2015, yet in less than three months, they produce a bill that has significant changes and undisclosed provisions that were not presented to the Task Force.  You have to know where you want to go first before you try to lead.  It is no wonder the Task Force has created their own competing proposal for PSPRS reform, which we will cover in the next post.