Tuesday, December 16, 2014

What PSPRS can learn from the Arizona State Retirement System (ASRS)

If you want to see an illustration of what is wrong with PSPRS, check out this article, "Public workers, employers to pay less for pension plan," by Craig Harris from the December 5, 2014 edition of the Arizona Republic.

Mr. Harris writes about the fiscal year 2016 contribution rates and COLA's for employed and retired members, respectively, of the Arizona State Retirement System (ASRS).  ASRS is the largest defined benefit pension system in the state.  It basically covers any non-federal government worker in Arizona who does not work in public safety, corrections, or as an elected official or does not work for the cities of Tucson or Phoenix.  This includes the three state universities, community colleges, school districts, and state, county, and municipal governments.  It is a huge system with assets about four times that of PSPRS.

ASRS is often held up as an exemplar when compared to PSPRS, and ASRS is a stick with which critics like to beat PSPRS.  This has especially been the case over the past two years when so much negative attention was focused on PSPRS' former Administrator and staff.  This is not an unfair comparison because it is funded at almost 77%, significantly better than PSPRS' 49% funding ratio, and returned 18.6% last fiscal year versus 13.2% for PSPRS.  However, Mr. Harris gives some important details about ASRS that can give us some some understanding as to why ASRS is in such better shape than PSPRS that goes beyond any difference in the funds' respective management.

The article states that ASRS' employers and employees will see a drop in their contribution rates next fiscal year.  The drop is small from 11.48% to 11.35% but shows that ASRS is moving in a positive direction.  This also means that ASRS employees will pay less next fiscal year than PSPRS employees, who will see their contribution rate increase (and finally top out) at 11.65%.  As far as I know, all non-public safety employees in Arizona must also pay into Social Security, which is fixed at 6.2% apiece for the employer and employee

Like Social Security, ASRS equally splits the annual required contribution (ARC) between the employer and employee.  This is starkly different from PSPRS where employees will be capped at 11.65% next year, but employers have an open-ended commitment to the remainder of the ARC.  For next fiscal year, PSPRS has an average employer contribution rate of  over 41%.  Individual employer rates can be much worse, such as that of the City of Tucson which will have contribution rates in the mid-60% range for both its police and fire departments.  This means that the City of Tucson will have to pay over $0.60 for every dollar of pensionable income paid to its police officers and firefighters.

The importance of equally splitting contribution rates cannot be overstated.  It is the best barometer employees have to measure the health of their pension system and receive forewarning that a problem is brewing.  Politicians are reactionary and will act only after the problem becomes too big to ignore.  The higher ranks of public safety unions tend to be comprised of more senior members who have little incentive to advocate for proactive changes that may adversely affect their own retirements.  Therefore, a rising contribution rate can work as an early warning system for rank-and-file employees when past and/or current policies begin to show deleterious effects on PSPRS and, at the very least, force consideration of corrective actions.

PSPRS was about 127% funded on June 30, 2001.  PSPRS was 49.2% on June 30, 2014.  ASRS was 113% funded on June 30, 2001 (but had actually peaked at 120% funded the previous fiscal year) and was 77% funded on June 30, 2014.  During this 14-year period, ASRS employers and employees saw contribution rates increase from 2.49% (FY 2002) to 11.35% (FY 2016).  PSPRS employees had a fixed rate of 7.65% until fiscal year 2012 when it began to increase incrementally, reaching the maximum rate of 11.65% in fiscal year 2016.  The average PSPRS employer rate increased from 4.21% (FY 2002) to 41.08% (FY 2016).  We see in ASRS a steady increase in the contribution rate that was shared equally by employer and employee.  ASRS began with a lower contribution rate than PSPRS and raised it to meet funding shortfalls and now is in a position to begin lowering it back down.  On the other hand, PSPRS' fixed employee contribution rate hid rapidly escalating pension shortfalls from employees, who are now in a worse financial position than ever as increased employer contribution rates eat into their current wages.

As well as having a more transparent method of allocating ARC's, ASRS has a stricter COLA policy.  Mr. Harris writes:
For a permanent benefit increase to kick in, the trust must produce a rate of return in excess of 8 percent — the assumed rate of investment growth — for 10 years and generate a pool of excess earnings.
I am not sure how ASRS determines when there is "a pool of excess earnings," but ASRS, unlike PSPRS, has a proper understanding of COLA's.  We will not go into the details of the Fields decision again here, but even those whom the decision benefited must acknowledge that it is bad for all PSPRS members, working or retired.  It is simple common sense that a pension system cannot pay COLA's when it is underfunded, especially when it is less than half funded.  Paying COLA's to retirees from an underfunded pension is simply consuming the seed corn that is necessary to bring PSPRS back to financial health.  As in the case of employees and contribution rates, the real and pernicious damage caused by the pre-SB 1609 COLA formula was hidden from retirees, despite the potential financial risk to themselves and the certain financial burden it places on those that follow them in public safety careers.

While ASRS and PSPRS started at the same place in 2001, their financial fortunes have diverged dramatically over the past 14 years.  Both systems had to endure the dot.com crash and Great Recession, yet ASRS is in such a better position than PSPRS.  How did this happen?  Even if we attribute some of this to the systems' respective management teams, we cannot deny that PSPRS' problems went unaddressed for much longer than ASRS'.  ASRS was increasing employer/employee contribution rates and cutting retiree COLA's well before the Great Recession.  The legislature and public safety unions did nothing about PSPRS until well after the market crashed for the second time in the decade, and the state firefighters' union was even denying any reform was necessary at the time SB 1609 was passed, though they are now advocating their own bad reform proposal.

Obviously, ASRS is better designed than PSPRS and already has mechanisms in place to better allocate costs between workers, retirees, and employers.  These mechanisms makes financial sense, but more importantly, they ensure that every stakeholder is aware of and bears the pain of pension funding shortfalls.  This is something that is sadly missing from PSPRS.  If employees saw their checks shrinking year on year and retirees saw their COLA's diminished or eliminated, it would have forced them to look more critically at the policies that were slowly depleting PSPRS, and hopefully, do something about them before they spiraled completely out of control.

Monday, November 24, 2014

The sideshow finally ends: Completed federal investigation into PSPRS real estate valuations finds no criminal wrongdoing.

This article, "Arizona public safety pension fund cleared in probe," by Craig Harris appears in today's Arizona Republic.   It references a letter by U.S. Attorney Elizabeth Strange to PSPRS' attorney that states:

As you are aware, the U.S. Attorney’s Office for the District of Arizona (“USAO”) and the Federal Bureau of Investigation (“FBI”) have been conducting a criminal investigation concerning certain valuation decisions and disclosures made by your client, the Public Safety Personnel Retirement System (“PSPRS”).
I can now confirm, through this letter, that your client is not a subject or target of the investigation. Based upon our joint investigation with the FBI, at this time we do not believe that PSPRS committed any criminal misconduct. This Office takes no position on civil or administrative liability, however, as our review focused exclusively on whether PSPRS engaged in criminal conduct in violation of federal law. Thank you for your assistance and professional courtesy in this matter.

I hope that this finally ends this whole sorry episode.  PSPRS had (and still seems to have) a disproportionate share of its real estate portfolio invested with Desert Troon.  This never made any financial sense, but neither did PSPRS' former equity-heavy portfolio and appears to be a legacy of past administrations.  However, the notion that PSPRS staff knowingly inflated real estate valuations for the express purpose of triggering their own bonuses always seemed absurd to me. 

This blog addressed the issue of potential criminal wrongdoing in the January 2014 post, Notes on a (PSPRS) scandal.  Readers can see that post for more detail, but in short, PSPRS addressed the problems noted by the Arizona Auditor General and revalued the Desert Troon portfolio accordingly.  In the end, the adjusted valuations done per the Auditor General's required standards were closer to the allegedly "inflated" Desert Troon valuations than they were to the "correct" and lower, initial valuations.  This hardly makes the case for a criminal conspiracy.  What it does make the case for is a more diversified real estate portfolio.  A better real estate portfolio would be one in which the investment in a single company would not impact PSPRS' total value to such an extent that staff bonuses could even remotely factor into the choice of a valuation methodology.  A better real estate portfolio would be one in which its value can be clearly determined and not be so opaque that a consensus can not be reached even among PSPRS' own in-house personnel and the Board of Trustees.

One final absurdity is that, in addition to all the unnecessary legal costs incurred by PSPRS to defend itself against charges of criminal behavior, the state of Arizona is on the hook for the private legal expenses of the four former PSPRS staffers who accused PSPRS of misconduct.  According to the Arizona Republic, Desert Troon is suing the four employees for "engaging in a post-employment conspiracy to defame and falsely disparage senior management at the company and the pension system."  Hopefully, for the sake of the former employees and Arizona taxpayers, Desert Troon will drop the lawsuit now that the U.S. Attorney has exonerated PSPRS of any wrongdoing, but who knows what they will do, especially if these accusations led to lost business for their company.  Some expressed outrage that former PSPRS Administrator Jim Hacking had a stipulation in his severance package that PSPRS would pay any legal costs "relating to actions taken in the course and scope of his employment" with PSPRS, but now it appears that PSPRS' accusers could end up costing taxpayers more.

Now that the sideshow is over maybe the misplaced outrage can be redirected where it should have gone in the first place.  Issues like pension spiking, unsustainable COLA's, intergenerational inequities, and the fragility of PSPRS in the face of future financial crises are the real problems that plague PSPRS.  People got their investigation and they got Mr. Hacking's job, now can we end the collective tantrum and move on to more important things?

Tuesday, November 18, 2014

The financial markets will not save you: the limited effect of investment returns on PSPRS' funding ratio

While we are on the subject of investment returns, I thought it would be interesting to see the effects past years' investment losses have on PSPRS' funding ratio.  The following is taken from PDF page number 23 of the 2014 PSPRS Consolidated Actuarial Valuation Report:

A. Beginning Year Funding Value $ 5,905,509,127
D. Non-investment Cash Flow $    (65,772,608)
E.Amount for Immediate Recognition $    461,000,892

F1. FY14 (Just ended)  $    33,458,496
F2. FY13  $      9,542,555
F3. FY12  $  (72,234,304)
F4. FY11  $    40,557,028
F5. FY10  $      9,473,791
F6. FY09  $ (183,695,537)
F7. FY08  $ (118,855,348)

G1. End of Year Funding Value (Prelim)  $ 6,018,984,092

Total Accrued Liability  $12,233,016,817
Funding Ratio 49.20%

This shows how PSPRS calculates its funding ratio.  The funding ratio is calculated by dividing its funding value (a valuation of its investments as of June 30, 2014) by its total accrued liability (what it needs to pay all the benefits it owes to retirees and current workers).  Calculating the funding value is not as simple as reporting the market value of all its investments as of June 30. 2014.  PSPRS, like many pension systems, uses a smoothing period when recognizing investment gains and losses.  PSPRS uses a seven-year period, while other systems use longer or shorter smoothing periods.

The smoothing period lessens the effect of year-to-year fluctuations in market returns so that funding ratios and contributions do not dramatically change from year to year.  This is especially important to employers who have to budget for employee costs and do not want their contribution rates yoyoing up and down each year.  With the seven-year smoothing period that PSPRS uses, this means that only 1/7th of each gain or (loss) incurred over the last seven years is recognized in the current year's  funding ratio.  Lines F1-F7 represent 1/7th of the gains and (losses) of each of the past seven years above or below the 7.85% expected rate of return (ERR).  The $461 million in Line E represents the expected 7.85% return that PSPRS should have earned on its investments in fiscal year (FY) 2014, which ended June 30, 2014.  This amount is recognized immediately.  The $33,458,496 in Line F1 represents 1/7th of the amount over 7.85% that PSPRS earned in FY14.  This means, for funding purposes, any year that PSPRS does not achieve its ERR will show a loss.

Each year, the oldest year drops off and is replaced by the newest year.  Looking at the table we can see that the two oldest years, FY08 and FY09 covering the two-year period from July 1, 2007 to June 30, 2009, are responsible for gigantic losses to PSPRS.  Over $118 million in losses will fall out of next fiscal year's calculations, and over $183 million in losses will fall out when FY16 ends June 30, 2016.  Hopefully, these losses will be replaced by large gains, but regardless, it is unlikely that losses of such size recur unless we have another financial crisis of the magnitude of the Great Recession. The funding ratio should increase, and that is good news for all of us and our employers. A higher funding ratio will mean lower employer contribution rates and more money available in employers' budgets.

So how much will the funding ratio increase when these losses drop off?  It is impossible to predict what will happen this fiscal year, so the best we can do is simply change some of the amounts in Lines F1-F7. I tried several different scenarios.  The first scenario used was one where PSPRS had suffered no losses or gains in either FY08 or FY09.  This would mean that PSPRS earned exactly 7.85% each of those years.  Under this scenario the End of Year Funding Value (Line G1) would increase to $6,321,534,977.  Liabilities of $12,233,016,817 would remain the same in all scenarios, so the funding ratio would go from 49.20% to 51.68%, an increase of 2.47%.

In the second scenario, I made it so PSPRS suffered no losses or gains in FY08, FY09, and FY12 and earned exactly 7.85%.  Line G1 increased to $6,393,769,281 and the funding ratio improved to 52.27%, an increase of 3.06%.

In the third scenario, I made it so PSPRS, instead of suffering losses, actually gained the same amount each year in FY08 and FY09 as it did in FY14, $33,458,496.  Line G1 increased to $6,388,451,969, and the funding ratio increased to 52.22%, an increase of 3.02%.  The increase here is less than the second scenario since the gains plugged into FY08 and FY09 do not fully make up for the loss in FY12.

In the fourth, most optimistic scenario, I made it so PSPRS actually gained the same amount each year in FY08, FY09, and FY12 as it did in FY14.  Line G1 increased to $6,494,144,769, and the funding ratio improved to 53.09%, an increase of 3.88%. 

These numbers are very sobering.  The losses from FY08 and FY09 falling out of the seven-year smoothing period produce an immediate gain of almost 2.5% in the funding ratio.   That is great.  However, when we look at the most optimistic scenario where all the loss years were turned into years of gains similar to FY14, we only improve our funding ratio by another 1.4% above the initial 2.5% increase.  While I hope I am wrong about this, I think the the gains in FY14 are likely to be as high as PSPRS will ever earn in its current risk-adjusted portfolio.  This means that investment gains going forward will have limited effect on raising PSPRS' funding ratio in the near-term.

PSPRS investment returns through September 2014

The following table shows PSPRS' investment returns, gross of fees*, versus the Russell 3000 for September 2014, the third 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%

There is usually about a two-month lag in PSPRS reporting its investment returns.  This is usually not a problem, but with such volatile markets, it would be nice to see a shorter reporting time.

If there is a pattern for market returns for the current fiscal year, it is that there is no pattern. Year-to-date returns should return to positive since October 2014 returned 2.75%, though daily returns were a roller coaster ride.  November 2014 has had much less volatility and is up about 1.0% month-to-date.

* Returns, gross of fees, are used because PSPRS usually does not report returns, net of fees, 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, November 13, 2014

PSPRS actuarial reports by employer are now available

PSPRS actuarial reports by employer for the fiscal year that ended June 30, 2014 can now be found here.  These reports give the current funded ratios and contribution rates for fiscal year 2016, which starts July 1, 2015, for each individual employer.  PSPRS had previously posted the aggregate report, but each employer will have a different funded ratio and contribution rate depending on their own particular situation.

Friday, October 31, 2014

2014 Consolidated Actuarial Valuation Reports for PSPRS, CORP, and EORP

PSPRS has officially posted the Fiscal Year 2014 Consolidated Actuarial Valuation Reports for the three pension systems managed by PSPRS.  The reports are in a more user-friendly PDF format than the Board of Trustees' Meeting notes that were referenced in an earlier post.  The report for each system can be found at the following links:
Public Safety Personnel Retirement System (PSPRS) 2014 Annual Actuarial Valuation Report
Corrections Officer Retirement Plan (CORP) 2014 Annual Actuarial Valuation Report
Elected Officials' Retirement Plan (EORP) 2014 Annual Actuarial Valuation Report
Actuarial reports for individual PSPRS employers are not yet available, but funded ratios and employer contribution rates for fiscal year 2016, which starts July 1, 2015, can be found in the appendices.  Funded ratios can be found on Appendix III starting on PDF page 79.  Contribution rates can be found in Appendix IV starting on PDF page 85.