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Was it constitutional for Proposition 124 to replace PSPRS' permanent benefit increases with a capped 2% COLA?

In this blog I and multiple commenters have broached the subject of the suspect constitutionality of PSPRS' replacement of the old perma...

Saturday, December 1, 2018

Just in time for Christmas, here's something for everyone: the DROP, service purchases, COLA's, and investment returns through August 2018 (CORRECTED)

PSPRS had its November 2018 Board of Trustees meeting this week, and there are several things in the meeting materials that might interest PSPRS members:

Rollbacks of changes to the Deferred Retirement Option Program (DROP) and service buybacks

1. The changes to the DROP program affects both the interest paid on DROP contributions and member contributions to the DROP.

The change in member contributions to the DROP  This affects what used to be called Tier 1b members, members who were PSPRS members before January 1, 2012 but did not have 20 years in the system.  Tier 1a members were those with 20 years in the system before January 1, 2012.  Tier 2 and Tier 3 members are not eligible for the DROP.  Currently, if you are a Tier 1b member and are or will be in the DROP, you must continue to pay the 7.65% member contribution to PSPRS.  These accumulated contributions are repaid to you when you permanently leave employment, along with 2% interest.  This program, the Contributory DROP, will end in January 2019.

This means that if you are currently in the DROP you will be entitled to a refund of your accumulated contributions plus interest, minus taxes, as these contributions were pre-tax and did not have income tax withheld when they were first taken.  It appears that the interest rate will be PSPRS' assumed rate of return (ARR) at the time the contributions were taken.  This rate has gradually decreased since fiscal year (FY) 2012 from 8% down to the current ARR of 7.3% for FY 2019.  It also appears that the refunded contributions and interest will be handled like the refunded contributions from the Hall/Parker decisions with taxes taken out them at 22-25%.  Interest payments would not have taxes withheld and would be reported on a 1099 at the end of the tax year.  If this interest payment was paid as post-Hall/Parker, it would come in the form of a check or direct deposit from your employer.

If you were in the Contributory DROP and have retired, you should have received your accumulated contributions and 2% interest, but you will still be due some type of interest payment with the same aforementioned tax situation.  If you have yet to DROP, you will simply see an increase in your weekly pay as you will no longer pay the 7.65% member contribution once you enter the DROP.

Change in DROP interest rates  Currently, the DROP pays or would pay a Tier 1B member an interest rate on the accrued monthly retirement benefits in his DROP account that is equal to PSPRS' 7-year average return or the ARR, whichever is lower.  This 7-year average return is currently 6.60%, but since FY 2012 it has been as low as 3.10%. Prior to the implementation of SB 1609, the interest paid on a member's DROP contributions was the ARR, which has ranged between 7.3% and 8.0% since FY 2011.

This means that anyone who is currently in or has participated in the Contributory DROP will get some increase in their final DROP payment as the ARR has always been higher than the 7-year average return.  Those who DROP in the future will see their DROP contributions grow at whatever the ARR is at that time.

With this change in the DROP interest rate increasing his final DROP payment, PSPRS Board of Trustees Chairman Brian Tobin may literally be a Million Dollar Man during his first year of retirement.  It seems like a conflict of interest that he did not recuse himself from the final vote on a proposal that would give him such an immediate personal financial benefit, but it appears that his vote was necessary to pass the proposal as they barely had a quorum at the previous Board of Trustees meeting.  I have been informed that Mr. Tobin is in the non-contributory DROP, which means that Mr. Tobin's vote had no effect on his personal DROP benefit.  I apologize to Mr. Tobin and readers for this error.


2. Change in discount rate for service purchases

The DROP was always a late-career money grab for senior PSPRS members, so these changes will unfortunately just add to the unfunded cost of this benefit for Tier 1 members.  However, the change to service purchases will, at least partially, reverse an unfair change to PSPRS.  For more detail, about the original change, you can read about it in this post from July 2016, but the gist is that PSPRS will once again use PSPRS' ARR as the discount rate to calculate service purchases.

This had changed to a rate based on the 10-year US Treasury (T-bill) bill rate plus 2% or the ARR, whichever is lower.  As we know, interest rates had been low for a quite a while, and accordingly, so has the 10-year T-bill rate, making it the lower of the two discount rate.  This method has benefited  PSPRS since it forces members to value their time at a lower rate than PSPRS expects to earn on its own investments, forcing members to pay more upfront to buy their service time.  This turns members into another profit center for PSPRS.  So members were either being forced to donate money to PSPRS in order to purchase their service time or forgo the purchase completely, as this change made service purchases much more expensive and out of reach for many members.

Reverting to the use of the ARR will mean members' upfront payments will be expected to earn the same rate as the rest of PSPRS investments, making the upfront payment lower and more manageable.  Members will no longer be treated as a revenue source by PSPRS.  Those who purchased service at the lower rate can expect to get refunds when service purchases are recalculated at the higher ARR (7.3% or 7.4%, depending on when the time was purchased).  Tier 1 and Tier 2 members who have yet to purchase service time will have the cost calculated using the ARR in effect at the time of purchase.

As for Tier 3 members, the lower of the 10-year Treasury bill rate plus 2% or the ARR is still in effect.  As we can see, this policy is an injustice, not for merely constitutional reasons, but because it is out-and-out theft from PSPRS members.  Tier 3 members, many of whom I speculate will want to buy time from their military service in Iraq and Afghanistan, deserve to be treated the same as Tier 1 and Tier 2 members and not be ripped off by PSPRS.  Tier 3 members were sold out by the Professional Fire Fighters of Arizona (PFFA), PFFA president Bryan Jeffries, and the other state law enforcement unions and their personnel when the third tier was created to protect the disproportionately generous benefits of Tier 1 members.  Tier 3 members should judge these state public safety unions and their senior leadership by how hard they work to correct this injustice.

The relevant portion of the meeting materials can be found on PDF page 261-265.

PSPRS tries to explain why it pays so much in investment fees

PSPRS' management and Board of Trustees got their feelings hurt by the Pew Center for the States (Pew), which reported that PSPRS paid, far and away, the highest external management fees of the 44 funds that report returns, net of fees, for FY 2016, and they make an attempt to explain why they received this dubious honor.  Readers can see PSPRS' explanation on PDF pages 189-191.

In the end, PSPRS' explanation is meaningless without any context from the other 43 funds Pew included in its study.   Did all the other 43 funds profiled under-report to Pew the fees they paid?  Did Pew over-report PSPRS' fees while accurately reporting every other fund's?  Is PSPRS saying the researchers at Pew, who do these types of analyses all the time, don't understand the fee structure, or are they just biased against PSPRS?

I checked back at Pew's website, and I saw no corrections or clarifications to the report.  What still appears is that PSPRS paid the highest external management fees, which were more than double the next highest fund, and they had the third worst returns.

PSPRS FY 2018 Actuarial Report

The PSPRS FY 2018 Actuarial Report was not included in the meeting materials, just a set of PowerPoint slides.  The important information is that PSPRS' aggregate funded ratio improved slightly from 45.3% at the close of FY 2017 to 45.8% at the close of FY 2018.  The aggregate employer contribution rate increased slightly from 51.93% to 52.31% from FY 2017 to FY 2018.  Tier 3 members are accounted for separately from Tier 1 and Tier 2 members, and all Tier 3 employers, are funded between 75% and 125%.  More importantly for Tier 3 members, who must split contributions 50/50 with employers, the range of employee contribution rates is 9.50% to 10.88%, depending on the employer.  It is about an even split between rates going up and rates going down.  These Tier 3 contribution rates can be found on PDF page 311.  The new rates will go into effect in FY 2020 starting July 1, 2019.  Tier 1 and Tier 2 members' contribution rates are fixed at 7.65% and 11.65%, respectively.

PSPRS expects to have its final consolidated annual report and actuarial reports complete by the end of the year.  Members can find out the status of their own employers' funded ratios and contribution rates when those reports drop sometime this month.

PSPRS investment returns through August 2018

The following table shows PSPRS' investment returns, gross of fees*, versus the Russell 3000 through August 2018, the second month of fiscal year (FY) 2019, with the past five FY end 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%
6/30/2015 -0.73% 4.21% -1.67% 7.29%
6/30/2016 -0.32% 1.06% 0.21% 2.14%
6/30/2017 0.22% 12.48% 0.90% 18.51%
6/30/2018 -0.66% 7.76% 0.66% 14.78%





7/31/2018 1.03% 1.03% 3.32% 3.32%
8/31/2018 0.94% 1.98% 3.51% 6.95%

There is usually about a two-month lag in PSPRS reporting its investment returns.

Once again, there is not much to comment on so early in the fiscal year, especially with the volatile months of October and November still to be reported.  It will be interesting to see how PSPRS did those two months.  The Russell 3000 had a large loss in October 2018 but managed to earn 2.0% in November 2018.  PSPRS did not report results for September 2018 in these materials, even though they would normally be reported in the November meeting materials.  PSPRS did not have a Board of Trustees meeting in October 2018.

Inflation and COLA's

2018 has not come to a close, but it seems likely that inflation in the Phoenix-Mesa area will be over 2% for the calendar year.  The 2018 first half inflation was 3.9%, meaning inflation in the second half of 2018 would have to be zero or negative for it to be be below 2%.  This means retirees should  expect a 2% COLA in their benefits starting July 1, 2019.

Thank you for reading.  I hope everyone has a safe and happy holiday season.

* 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.  Returns, gross of fees, are used in the table for consistency.  Returns, net of fees, were 13.28% in FY 2014, 3.68% in FY 2015, 0.63% in FY 2016, 11.85% in FY 2017, and 7.07% in FY 2018.

Wednesday, October 3, 2018

PSPRS is number one! (in investment management fees, of course) plus investment returns through July 2018

Some of you may have received a recent email from PSPRS with this bit of information:

PSPRS generates $660 million in returns for FY18 

7.8 percent gross return rate helps trust tops $10 billion in assets 

ARIZONA – Arizona’s Public Safety Personnel Retirement System netted investment returns of nearly $660 million over the last fiscal year, with the help of strong performance by the trust’s public and private equity assets.
The fund’s investments generated a gross return rate of 7.8 percent for the year, helping the system, which serves more than 55,000 members, top the $10 billion mark in assets under management for the first time in its 50-year history. Net of fees, the overall returns stood at 7.1 percent for FY2018.
“Our investment team has made enormous strides in building a portfolio capable of producing solid returns while we take less risk than the vast majority of our peer funds,” said PSPRS Board Chairman Brian Tobin.  “It can be hard to show the value of a low-risk approach in a bull market but we have to keep perspective if we want to avoid the same mistakes that led to significant losses in the past. This strategy protects our members, Arizona employers and millions of taxpayers while the system continues to recover.”
Investments in private equity made possible by 2008 changes to state law have performed admirably by exceeding benchmarks based on the Russell 3000 index, which has grown steadily during the nation’s historic bull market featuring positive returns for most of the last decade.
PSPRS investment returns in asset classes including private equity, fixed income, private credit, global trading strategies, real assets and risk parity continue to meet or outperform long-term benchmarks, while overall returns were hampered by pre-recession joint venture real estate investments.
“Our portfolio is built around the fact that we need to invest responsibly because losses over the course of even a single year could prove disastrous for some employers and potentially harm our ability to meet our obligations to retirees,” said PSPRS Chief Investment Officer Mark Steed. “This requires a balanced strategy across multiple asset classes and far less reliance on the stocks and bonds that make up the typical investment portfolio.”
The 2018 fiscal year returns are below the 9 percent threshold required under state law to trigger pension increases for retirees of the Corrections Officer Retirement Plan and the Elected Officials Retirement Plan.
PSPRS investments generated just under $3 billion of investment returns over the past five years. Retirement plans managed by PSPRS typically distribute about $1 billion of retiree, survivor and disability benefits each year.
While we should not be surprised considering this comes from PSPRS' management, this press release is deceptive from nearly the beginning.  The sub-headline trumpets a "7.8% gross return rate," (actual was 7.76%) and you need to look into the second paragraph to see that PSPRS paid 0.7% in investment management fees and only earned 7.1% (actual was 7.07%) for fiscal year (FY) 2018.  This is 0.3% below PSPRS' assumed rate of return (ARR) for FY 2018, and 0.64% below its own benchmark of 7.74%.  If PSPRS included this information, the "7.8%" and "$660 million" figures do not look quite so good.  Even worse, PSPRS is paying more in investment fees than it has in past years, 0.69% in FY 2018 versus 0.63% in FY 2017.

The FY 2017 annual report states that PSPRS' assets were $9.3 billion as of June 30,2017.   For comparison the Arizona State Retirement System (ASRS) earned 9.5% in FY 2018.  If PSPRS had earned that additional 2.4%, it would have increased PSPRS' assets by $223 million.  In FY 2018, PSPRS paid $65 million in investment fees to earn $223 less than if ASRS had been managing PSPRS' assets.  Over the past ten years, ASRS' annualized returns were 1.9% per year higher than PSPRS' (7.4% versus 5.5%).  That additional 1.9% per year on $9.3 billion in assets would be worth nearly $2 billion in ten years, yet we keep hearing the same tired explanations from the likes of Board of Trustees Chairman Brian Tobin and new Chief Investment Officer (CIO) Mark Steed that PSPRS is well prepared for the next market crash.

PSPRS has already missed the last ten years of the current bull market during which the Russell 3000's annualized return was 10.24%.  I am not saying that PSPRS should simply invest all its money in the Russell 3000, but based on ASRS' results, it is obvious that there is a better strategy out there already being executed (within just a few miles of PSPRS' offices, I might add).  Look at ASRS' annual returns over the past 36 years.  Even after the rough patches in FY's 2000 and 2001 and FY's 2008 and 2009, ASRS more than earned back all it lost and more during each of the two fiscal years following 2000-01 and 2008-09.  Market downturns are unavoidable, but as ASRS shows, they are manageable.  On the other hand, like generals preparing for the last war, PSPRS' management is preparing for the last market crash.

PSPRS' own analysis shows that while they are only suffering 31% of market downside, they are only getting 44% in market upside.  If we look again at ASRS' returns over the last 36 years, there were 31 years of positive returns, with 20 of those years producing double digit returns, versus only five years of negative returns with only one year of double digit losses.  Capturing only 44% of those 31 years of positive returns to limit  PSPRS to only 31% of the losses in the five down years is not a good tradeoff.  Ben Carlson of A Wealth of Common Sense has a longer historical perspective on markets and the unpredictability of market crashes and bull markets.  Whenever Mr. Tobin and Mr. Steed, PSPRS Adminstrator Jared Smout and recently retired CIO Ryan Parham speak about PSPRS' current investment strategy, it always sounds like they are longing for another market crash that will validate the strategy, but I think the verdict is already in.  PSPRS' current investment strategy is a failure.

However, PSPRS does have one dubious achievement it can claim.  On September 26, 2018, the Pew Center for the States reported in its State Public Pension Funds' Investment Practices and Performance: 2016 Data Update that PSPRS paid the highest external management fees of the 44 funds that report returns, net of fees, for FY 2016.  As a percent of assets, PSPRS paid 2.23% in external management fees.  Not only did PSPRS top the list in external management fees paid, it ran away with the title, more than doubling second place South Carolina Retirement Systems, which paid 1.00% of assets in external management fees.  ASRS paid 0.49% of assets in external management fees in FY 2016.  Of the 44 pension funds listed, PSPRS was 42nd in 10-year annualized returns.  ASRS was 9th.  PSPRS also had the highest investment expenses at 1.76% of assests; ASRS was at 0.59% of assets.  These achievements all occurred in a fiscal year in which PSPRS earned a whopping 1.06%.

When I read that Mr. Parham was retiring as PSPRS CIO, I was hoping that he had been finally been forced out due to his consistent record of poor results and that more significant changes were in the offing .  However, that does not appear likely.  PSPRS' Board of Trustees has promoted his Deputy CIO Mark Steed to replace him, so we can expect PSPRS to continue with its failed investment strategy.

Finally, the following table shows PSPRS' investment returns, gross of fees*, versus the Russell 3000 through July 2018, the first month of fiscal year (FY) 2019, with the past five FY end 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%
6/30/2015 -0.73% 4.21% -1.67% 7.29%
6/30/2016 -0.32% 1.06% 0.21% 2.14%
6/30/2017 0.22% 12.48% 0.90% 18.51%
6/30/2018 -0.66% 7.76% 0.66% 14.78%





7/31/2018 1.03% 1.03% 3.32% 3.32%

There is usually about a two-month lag in PSPRS reporting its investment returns.

There is not much to comment so early in the fiscal year, but we once again see PSPRS lagging the Russell 3000.  For the 2018 calendar year, the Russell 3000 has returned 6.64%, double the 3.30% return of PSPRS over the same seven months. 

* 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.  Returns, gross of fees, are used in the table for consistency.  Returns, net of fees, were 13.28% in FY 2014, 3.68% in FY 2015, 0.63% in FY 2016, 11.85% in FY 2017, and 7.07% in FY 2018.

Sunday, September 2, 2018

PSPRS investment returns through June 2018 with a few other matters covered as well

The following table shows PSPRS' investment returns, gross of fees*, versus the Russell 3000 through June 2018, the last month of fiscal year (FY) 2018, with the past four FY end 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%
6/30/2015 -0.73% 4.21% -1.67% 7.29%
6/30/2016 -0.32% 1.06% 0.21% 2.14%
6/30/2017 0.22% 12.48% 0.90% 18.51%





7/31/2017 0.83% 0.83% 1.89% 1.89%
8/31/2017 1.06% 1.91% 0.19% 2.08%
9/30/2017 0.80% 2.72% 2.44% 4.57%
10/31/2017 0.64% 3.38% 2.18% 6.85%
11/30/2017 1.28% 4.70% 3.04% 10.10%
12/31/2017 0.66% 5.39% 1.00% 11.20%
1/31/2018 2.35% 7.86% 5.27% 17.06%
2/28/2018 -1.37% 6.38% -3.69% 12.74%
3/31/2018 0.65% 7.07% -2.01% 10.48%
4/30/2018 0.49% 7.59% 0.38% 10.90%
5/31/2018 0.82% 8.47% 2.82% 14.03%
6/30/2018 -0.66% 7.76% 0.66% 14.78%

There is usually about a two-month lag in PSPRS reporting its investment returns.

FY 2018 Earnings

So after a bit of a hiatus here, we can once again discuss PSPRS' investment returns and a few other matters.  PSPRS once again significantly lagged the Russell 3000.  For FY 2018 PSPRS earned only 52.50% of the Russell 3000.  PSPRS has been amazingly consistent in this regard.  During the past five fiscal years, PSPRS has earned 54.80%, 57.75%, 49.53%, 67.42, and 52.50% of the Russell 3000.  With the exception of FY 2017, the other four years all fell within about a pretty close eight percentage point range.  If we can expect PSPRS to capture only 50-60% of the Russell 3000 each year, the Russell 3000 will have to range between 12.17% and 14.60% in order for PSPRS to just earn its recently reduced expected rate of return (ERR) of 7.30%.  The following table shows even more of the consistent 50-60% capture rate:

Time Period Captured
FY 2014 54.80%
FY 2015 57.75%
FY 2016 49.53%
FY 2017 67.42%
FY 2018 52.50%
3-Year Annualized 60.45%
5-Year Annualized 58.39%
10-Year Annualized 58.46%

The 7.76% FY 2018 is gross of fees.  Net of fees, PSPRS likely earned only about 7.25%, in FY 2018, as PSPRS earnings are reduced about a half-percent after investment fees are subtracted.  This return falls short of PSPRS' FY 2018 ERR of 7.40%.  The final FY earnings rate, net of fees, is reported in September.

So how did PSPRS do versus the Arizona State Retirement System (ASRS) and PSPRS' own Cancer Insurance Plan (CIP) in FY 2018?  ASRS earned 9.50% and the CIP earned 6.72% in FY 2018.  ASRS earned 2.25% more on its assets than PSPRS.  The CIP, a simple fund consisting of 50% equity, 45% bonds, and 5% gold, made about a half-percent less than PSPRS.  PSPRS' assets at the end of FY 2017 were $9.3 billion.  An additional 2.25% on $9.3 billion would have earned PSPRS an additional $209 million in FY 2018.

Chief Investment Officer (CIO) Ryan Parham retires

The lackluster investment numbers for FY 2018 are a fitting coda to Mr. Parham's unimpressive career at PSPRS.  According to this database published by ABC 15 in November 2017, Mr. Parham was the second-highest, non-university system employee in the state of Arizona.  Among non-university system employees, his $268,000 annual salary is exceeded only by that of ASRS Director Paul Matson, who earned $285,000.   What is even more bizarre is that Mr. Parham earned over $66,000 a year more than ASRS' CIO Karl Polen, despite ASRS much better earnings history.

PSPRS Board of Trustees Chairman Brian Tobin had this to say about Mr. Parham:
Ryan Parham’s accolades and results in a fiercely difficult marketplace tell a clear story: He has been one of the best in the business for more than a decade,” said Tobin. “Even with Ryan gone, the new path he’s helped set and the changes in law that needed to occur have the system well-positioned moving forward. PSPRS has positive momentum. And we’ve never been more committed to serving our members and our fellow taxpayers. Ryan and his team worked exceedingly hard for years to help make that the truth.
Heckuva job, Hammy!  I suppose for Mr. Tobin, who will soon receive an $817,000 Deferred  Retirement Option Plan (DROP) and a $134,000 annual retirement benefit, life looks great, and maybe that is why he would consider Mr. Parham "one of the best in the business."  Personally, Mr. Tobin is going to make out extremely well.  However, if he looked at the investment performance of PSPRS over the past 14 years, especially in comparison to ASRS, and how it has affected the financial security of thousands of PSPRS members, he might call Mr. Parham's career at PSPRS a bit of a disappointment.

As for his commitment to serving PSPRS members, let's go back to Mr. Parham's own words about investment returns in a 2014 editorial in the Arizona Capitol Times:
PSPRS wants its retirees to enjoy increases, but we are incentivized to seek lower returns in the range of 9 percent to maximize earnings that can be applied to cover – and hopefully reduce – unfunded liabilities.
I guess I don't have the enlightened understanding and appreciation that Mr. Tobin has for all of Mr. Parham's hard work, commitment, and dedication to underperformance.  I just thought PSPRS' Chief Investment Officer best served PSPRS members by maximizing investment returns.

Inflation and COLA's

Retirees should be getting their first cost of living allowance (COLA) under the new system implemented with the passage of Proposition 124 in May 2016.  The COLA is based on the Phoenix-Mesa regional consumer price index for all urban consumers (CPI-U) at the end of 2017.  The COLA is limited to the lower of the actual Phoenix-Mesa CPI-U or 2%.  The actual CPI-U at the end of 2017 was 2.5% so retirees are getting a 2% COLA based on their individual monthly benefit.  The Phoenix-Mesa CPI-U for the last half of 2017 was 2.2% but was 3.9% for the first half of 2018.  This means the inflation rate for FY 2018 was about 3.0%.  1-2% a year may not seem like a lot but over 20-25 years it will mean a significant loss in purchasing power, and of course, any inflation higher than that would do even more damage to a retiree's income.

Ballot measure affecting retirees in the EORP and CORP

This ballot measure would change the permanent benefit increase (PBI) system in the Elected Officals' Retirement Plan (EORP) and the Corrections Officers' Retirement Plan (CORP) to the COLA system currently in place at PSPRS.  The measure does not have proposition number yet but more information can be found at Ballotpedia.  This measure is likely to pass, which is when it should become interesting.  I suspect a CORP or EORP retiree (especially one in particular) will file a lawsuit claiming that this measure is unconstitutional under the Contract Clauses of the Arizona and US Constitution.  If you are curious about those constitutional issues, they are discussed here and here.  If someone can successfully convince the courts that this measure is unconstitutional, it would mean that Proposition 124 was also unconstitutional.  If they were to lose the case, especially at the US Supreme Court, it could empower legislatures and/or special interest groups throughout the country to unilaterally alter pension benefits that have been consider inviolable.  This will be fascinating to watch play out.

That is a short recap of some of the recent news about PSPRS.  Have and safe and happy Labor Day.

* 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.  Returns, gross of fees, are used in the table for consistency.  The past four years fees have reduced the final annual reported return by about a half percent.  Returns, net of fees, were 13.28% in FY 2014, 3.68% in FY 2015, 0.63% in FY 2016, and 11.85% in FY 2017.

Thursday, April 26, 2018

PSPRS investment returns through February 2018 with a recommendation to the Arizona Legislature on how to better oversee PSPRS

The following table shows PSPRS' investment returns, gross of fees*, versus the Russell 3000 through February 2018, the eighth month of the current fiscal year (FY), with the past four FY end 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%
6/30/2015 -0.73% 4.21% -1.67% 7.29%
6/30/2016 -0.32% 1.06% 0.21% 2.14%
6/30/2017 0.22% 12.48% 0.90% 18.51%





7/31/2017 0.83% 0.83% 1.89% 1.89%
8/31/2017 1.06% 1.91% 0.19% 2.08%
9/30/2017 0.80% 2.72% 2.44% 4.57%
10/31/2017 0.64% 3.38% 2.18% 6.85%
11/30/2017 1.28% 4.70% 3.04% 10.10%
12/31/2017 0.66% 5.39% 1.00% 11.20%
1/31/2018 2.35% 7.86% 5.27% 17.06%
2/28/2018 -1.37% 6.38% -3.69% 12.74%

There is usually about a two-month lag in PSPRS reporting its investment returns.

We finally have data from February 2018, which was an extremely volatile month for the markets with the Russell 3000 losing 3.69%, versus a loss of 1.37% for PSPRS.  This means PSPRS suffered only 37.13% of the monthly loss of the Russell 3000.  On the other hand, PSPRS only captured 44.60% of the gain in January 2018.  In the latest information provided by the Arizona State Retirement System (ASRS), ASRS' fiscal YTD return through April 17, 2018 is about 9.0%.  PSPRS' Cancer Insurance Plan (CIP) has earned 6.42%, net of fees, fiscal YTD.  The Russell 3000 had another loss of about 2.5% for the month of March 2018, and as of April 25, 2018, the Russell 3000 is up about 1% for the month of April with two trading days left.  It will be a close call whether PSPRS achieves its assumed rate of return (ARR) of 7.4% by the end of June.

For the fiscal YTD, PSPRS has captured almost exactly 50% of the gains of the Russell 3000.  This once again fits PSPRS' pattern of returning 50-60% of the Russell 3000.  At this capture rate, the Russell 3000 must earn between 12.33% and 14.80% in order for PSPRS to earn 7.4%.  PSPRS' actuaries are recommending that PSPRS lower this rate to 7.3% based on an experience study from last year.  Tier 3 members have an ARR of 7.0%.  Any decrease in the ARR will increase current liabilities as investment earnings going forward will be lower, which means contribution rates for Tier 1 and Tier 2 members will have to increase.  This will cause an increase in employer contributions as Tier 1 and Tier 2 members' contribution rates are fixed at 7.65% and 11.65%, respectively.

There was a bill that was attempting to tie PSPRS' ARR to the 3-year rolling average of the 20-year treasury constant maturity rate.  The bill would have forced PSPRS to adopt an ARR that was not more than 2% higher than this rate.  PSPRS would have been forced to drop the ARR 0.25% every year until that target was reached.  Fortunately, this bill was amended, and the language was changed to limit PSPRS from raising its ARR unless PSPRS was at least 80% funded.  This original bill was foolish, as it would have forced PSPRS to drop its ARR down to somewhere around 5%, which would have devastated every employer in the state and hit Tier 3 employees in the defined benefit pension especially hard.  These Tier 3 employees are required to split normal costs and unfunded liabilities 50/50 with employers, and once the ARR dropped below 7%, they would see increases in their pension contributions.  There is no way that this could have worked.

If the Arizona Legislature wants to impose more control over  PSPRS, it should start by giving another state agency, such as the Office of the State Treasurer or the Auditor General, the authority to select PSPRS' actuaries, pension consultants, and accountants.  We know that PSPRS' Board of Trustees and senior management cannot be trusted.  See this passage from The League of Arizona Cities and Towns PSPRS Task Force Report from August 2015:
It is also important to point that prior to FY 2015-16, the cost of the PBI (permanent benefit increase) was not included in the employer contribution rate. Excluding the PBI from the calculation effectively underestimated the normal cost of the pension plan, causing it to manifest itself in the unfunded liability. This issue was identified by PSPRS actuaries several years ago, but the PSPRS Board did not take action to address it. (boldface mine)
Despite this, the PSPRS Board of Trustees is still allowed to contract for these services.  It would be far better if the actuaries, consultants, and accountants were reliant on another state agency to award these contracts.  Their work would be more independent and not influenced by concerns over continued business with PSPRS, if they shined a negative light on the Board or senior management. Their reports and recommendations would also circulate outside of PSPRS for review and analysis.  The PSPRS Board and senior management would then be under pressure to adopt the recommendations of these independent companies or justify to the Arizona Legislature why they cannot.  If PSPRS repeatedly ignored the recommendations without justification, the Legislature or Governor could make personnel changes at PSPRS or pass legislation to force good policies.  This would be a good first step in holding PSPRS accountable.

* 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.  Returns, gross of fees, are used in the table for consistency.  The past two years fees have reduced the final annual reported return by about a half percent.  Returns, net of fees, were 13.28% in FY 2014, 3.68% in FY 2015, 0.63% in FY 2016, and 11.85% in FY 2017.

Wednesday, April 11, 2018

Let's get ready to rumble! Will we see Round 3 of Fields v. EORP, and how would it affect PSPRS members?

As some of you may have noticed, posts are getting less frequent here.  There simply isn't as much going on now that the Fields and Hall cases have been settled, or at least, as it relates to issues that concern most PSPRS members.  Understandably, most PSPRS members want information about things that will affect their own finances, particularly anything that might change current wages or monthly retirement checks.  So just as I was starting to consider closing up shop, PSPRS sent this out:
Referendum headed to ballot
Arizona voters will be asked to reform the permanent benefit increase formula for retired members of the Elected Officials Retirement Plan and the Corrections Officers Retirement Plan. This question will be wrapped into one referendum appearing on the November 2018 ballot.

The reforms to pension increases for CORP and EORP largely mirror those included in Prop 124, which voters passed in May 2016 to replace the permanent benefit increase (PBI) for public safety retirees with a cost-of-living-adjustment model.

The PBI reform to CORP was included in Senate Bill 1442, which was signed into law last year and created additional benefit reforms. The legislation impacting EORP, House Bill 2545, was signed into law this week by Governor Doug Ducey.

As was the case with Prop 124, the changes to CORP and EORP require subsequent voter approval to amend the state constitution to adjust the retiree benefit structure. 

The replacement of the permanent benefit increase (PBI) for CORP and EORP retirees is supported by the PSPRS Board of Trustees due to the urgency to bring stability and sustainability to PSPRS-managed retirement plans. Reform related legislation passed through the state Legislature with unanimous votes or overwhelmingly majorities.

Employers and those interested are strongly encouraged to read all reform legislation related to PSPRS-managed retirement plans. This email is not intended to provide details on all pending or proposed reforms.
The Arizona Legislature is going to try and change how the Elected Officials' Retirement Plan (EORP) and Corrections Officers Retirement Plans (CORP) pay post-retirement benefit increases via a voter referendum in the 2018 general election.  EORP and CORP still use a permanent benefit increase (PBI) system similar to what PSPRS had for Tier 1 members prior to the passage of Proposition 124 in May 2016, which replaced PSPRS' old PBI formula with a capped 2% cost of living allowance (COLA) that is based on the inflation rate in the Phoenix-Mesa area.  PSPRS' COLA applies to ALL PSPRS members, regardless of tier, though Tier 3 members have additional restricions on the payment of their COLA's.

For Tier 1 CORP members (retired before July 1, 2011), half of any annual investment earnings over 9% go into a reserve fund that is used exclusively to pay PBI's of up to 4% of the average normal benefit.  For Tier 2 CORP members (retired July 1, 2011 or later, a sliding scale is used to pay the PBI.  The scale is based on the funded ratio of CORP.  Tier 2 members can get a PBI from 2-4% based on the funded ratio between 60-80%.  You can read more about the PBI's in the CORP Member Handbook.  For EORP members, the PBI rules are the virtually the same.  EORP members are not designated by tiers (tiers are for the little people, apparently) but are broken into in two groups with the same cutoff date as CORP members.  The only major difference I see in the EORP Member Handbook is that the EORP PBI's are based on a member's individual benefit, not the average normal benefit. which makes sense since there is wide range in salaries among EORP members.

On March 23, 2018 the Arizona Republic published this editorial by PSPRS Board of Trustees Chairman Brian Tobin about the dire state of EORP.  While I do not want to get into what Mr. Tobin had to say in his editorial, we should note the complete cluelessness and utter lack of credibility of a public servant who will walk away with nearly $1 million in his first year of retirement telling taxpayers that they need to pony up more money to pay for a broken pension system.

It might be tempting for PSPRS members to say what is good for the goose is good for the gander, especially when it involves the benefits of "elected officials."  However, the 2017 consolidated annual financial report (CAFR) shows the average annual PSPRS service pension is higher than the average annual EORP service pension ($56,232 vs $54,860), while CORP's average annual service pension is only $28,977.  So even if you have no sympathy for retired politicians and judges, many of whom had other sources of income during their working lives and shorter careers in public service, we should not forget that CORP members will be especially hard hit by a change in their PBI's.  No CORP member is getting rich off PBI's, and in fact, the average active CORP member's salary is lower than the average benefit of PSPRS and EORP retirees. This might be something PSPRS members should  keep in mind when it comes to fill out our ballots in November.  The PSPRS press release states that both CORP and EORP will be covered under a single referendum, rather than separately, cynically assuming that voters will want to punish "elected officials" more than they want to help retired corrections officers.

If I had to predict, the referendum changing EORP and CORP's post-retirement increases from a PBI to a COLA will pass.  I cannot see any organized opposition from EORP members (There are just not enough of them.), and I have never seen CORP members (Are they even unionized?) flexing any financial or political muscle in Arizona.  I do not expect much to happen between now and November 6, 2018, but if the referendum passes, that's when I suspect things will really start to heat up because standing on the sidelines is EORP's arch-nemesis, retired Maricopa County Superior Court Judge Kenneth Fields.  His successful challenge to SB 1609 in 2011 was over the very issue of alteration of the PBI formula.  He also won another case against EORP in 2017 over how much employers were required to pay in contributions.  EORP currently has a fixed employer contribution rate that is grossly inadequate to fund the pension.

The curious thing about this is that EORP must be funded.  It makes no sense for Legislature could not set a fixed employer contribution rate and deliberately starve it of funding.  The obligation to retirees would not disappear because the state refused to make employers pay the necessary contributions.  EORP's defined benefit pension will have to be funded until the last member or survivor dies, and for some perspective, see this story.  So what was the purpose of setting a fixed employer contribution rate that is only half or one-fourth of what is needed?  I do not like conspiracy theories, but what else could it be but to force EORP into such a financial crisis that a radical change would be required.  For instance, maybe something like changing EORP's PBI to a capped COLA like PSPRS?  The Legislature tried to change the PBI's less radically in 2011, and Judge Fields beat them in court.  He beat them again last year.  If we can all see how this was set up, an experienced attorney and retired judge surely can, and I am sure that Judge Fields knew all along what the Legislature was trying to do.

Will we see round three in Kenneth Fields v. EORP?  I suspect so.  This is a man who has won a case against Maricopa County over retaliation by former Sheriff Joe Arpaio and the former County Attorney.  He also attempted to force former PSPRS Administrator James Hacking to attend remedial classes in the role of a public fiduciary.  We have previously discussed the constitutionality of changing PSPRS' PBI formula, and if you are not familiar with the issues, you can see this post, "Was it constitutional for Proposition 124 to replace PSPRS' permanent benefit increases with a capped 2% COLA?"  Long story short is that changing the PBI unilaterally, even if by voter referendum, appears to violate the contract clauses of both the Arizona and US Constitution, assuming the contract clauses trump Article 29 of the Arizona Constitution.

I would suspect that this is the legal argument Judge Fields would take to overturn any changes to EORP's PBI made via referendum.  He will have a tougher audience this time around, since Governor Doug Ducey has appointed three new justices to the Arizona Supreme Court since his first lawsuit agains SB 1609, though I do not know how may would recuse themselves from the case due to a personal stake in the outcome.   However, this is a case that seems tailor-made for the US Supreme Court since it would affect every public pension system in the country.  I suspect that no matter who wins, the loser would appeal to the highest court in the land.

While I believe that the PBI is horrible financial policy and should be eliminated, based on my layman's understanding of contracts, the electorate simply cannot vote to unilaterally alter a contract except in very extraordinary circumstances, like bankruptcy or fraud, and you certainly cannot initiate a Sopranos-like bust out of a pension in order to create extraordinary circumstances.  Suppose we have another financial crisis, not even one as bad as in 2008-09, could the legislature or special interest group place a measure on the ballot that implemented across the board cuts to existing pensions or raise contribution rates 5% or 10%?  How would those be different than Proposition 124?  It appears that the Arizona Legislature has gotten a taste for legislating via referendum.

So possibly standing in the way of all this is one man.  Judge Fields seems to be a disappearing breed, a man willing to fight on principle.  Does anyone really believe that he cares about the financial losses he might suffer over changes to the PBI?  You have to already be a successful attorney to get a judgeship in the first place, and it appears he is still quite active in the legal field.  So his lawsuits have been fought strictly to hold the government accountable.  Most of us expect promises to be kept, especially financial ones to those who are no longer working, but there are not that many that are willing to fight so hard to make sure they are.  So CORP members can take a little heart, they could have a white knight coming to their rescue, but they will have to wait until after the election to see.

What does this mean for PSPRS members?  If the EORP referendum passes and Judge Fields or some other EORP member (EORP has a lot of lawyers among its membership) sues to overturn it, I have not doubt that a CORP member will also file his or her own lawsuit the same way PSPRS members piggy-backed onto the EORP lawsuits by Judge Fields and Judge Hall.  However, PSPRS member unions started all this referendum nonsense in the first place, and it will be two and a half years since Proposition 124 was passed with no challenge made to it constitutionality.  Is there a timely filing requirement or other legality that would prohibit a PSPRS member from again piggy-backing onto an EORP lawsuit?  I guess like CORP members we will have to wait and see.  If this does happen, we will have a very interesting few years ahead of us.

We cannot end without remarking on the contrast between Judge Kenneth Fields and our "leaders" in Arizona.  We had the flaccid negotiating of the Professional Fire Fighters of Arizona (PFFA) and law enforcement unions against the Arizona Legislature and Reason Foundation.  These crack artists of the deal were willing to give away everyone else's benefits as long as they kept their deferred retirement option plan (DROP).  (Who cares about retirees keeping up with inflation or protecting Tier 3 members' paychecks from contribution increases?!  We are going to fight to the end to make sure Brian Tobin gets that $817,398 payment when he retires!)  Speaking of Mr. Tobin, this is someone who will not even stand up to PSPRS' management, the very group that he and the other trustees are supposed to oversee.  How can we expect him to call out the Arizona Legislature for manufacturing a crisis in order to bring about a "constitutional" change to diminish and impair retirees' benefits.  Can't Mr. Tobin at least stand up for CORP members now that a manufactured crisis for EORP is engulfing them, the lowest paid retirees of all?  He and the other Trustees represent CORP members as well.   How is that EORP members have one man fighting so effectively for them, while PSPRS members are stuck with such a group of spineless, selfish, and shortsighted leaders?  Too foolish to know that they were opening a Pandora's Box of pension chaos when they supported Proposition 124, they now want to open the lid again and see what other havoc they can let loose.

There is more to talk here on pension chaos and havoc, but that will have to wait for another post.

Thursday, March 1, 2018

Inflation, COLA's, the future of PSPRS, and investment returns through December 2017

The following table shows PSPRS' investment returns, gross of fees*, versus the Russell 3000 through December 2017, which is the midpoint of the current fiscal year (FY), with the FY end 2014, 2015, 2016, and 2017 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%
6/30/2015 -0.73% 4.21% -1.67% 7.29%
6/30/2016 -0.32% 1.06% 0.21% 2.14%
6/30/2017 0.22% 12.48% 0.90% 18.51%





7/31/2017 0.83% 0.83% 1.89% 1.89%
8/31/2017 1.06% 1.91% 0.19% 2.08%
9/30/2017 0.80% 2.72% 2.44% 4.57%
10/31/2017 0.64% 3.38% 2.18% 6.85%
11/30/2017 1.28% 4.70% 3.04% 10.10%
12/31/2017 0.66% 5.39% 1.00% 11.20%

There is usually about a two-month lag in PSPRS reporting its investment returns.

Through the first half of the current fiscal year (FY), PSPRS is returning about 48% of the Russell 3000.  PSPRS has pretty consistently been capturing 50-60% of the Russell 3000 as this table shows:

Time Period Captured
FY 2014 54.80%
FY 2015 57.75%
FY 2016 49.53%
FY 2017 67.42%
Calendar Year 2017 53.90%
3-year Annualized 67.00%
5-year Annualized 53.72%
10-year Annualized 55.23%

The exceptions are FY 2017 and the 3-year annualized returns, but the 50-60% range seems to hold for long and short periods and for periods of high and low returns.  The only data missing is a year of longer period(s) of negative return(s).  It will be interesting to see what the month of February 2018 does to these numbers as the Russell 3000 lost 3.69%.  This loss is lower than mid-February when the Russell 3000 was down as much as 8%, but we will see what PSPRS' alternative investments do to counteract the losses in equities.  Unfortunately we will not get to see these numbers until April.  The Arizona State Retirement System (ASRS) had a Board of Trustees meeting on February 23, 2018, and its meeting packet included returns up through February 12, 2018.  I do not know why PSPRS cannot provide more up-to-date numbers in its meeting packets.  Between January 29, 2018 and February 12, 2018, ASRS' FY 2018 return dropped approximately 3% from about 11% to about 8%.  These ASRS numbers come from a graph on PDF page 29 of the meeting packet.

Through the end of December 2017, ASRS looks to have had a FY return of approximately 8.50%, over 3% more than PSPRS through the same time period.  PSPRS' Cancer Insurance Plan (CIP) has returned 6.82%, net of fees, through December 2017, also beating PSPRS by about 2%, when we subtract a half percent in fees from PSPRS' returns.  If this 50-60% capture range remains consistent, the Russell 3000 would need annualized returns of 12.33% to 14.80% in order for PSPRS to achieve its assumed rate of return of 7.40%.

The meeting minutes from January 2018 show that the Board of Trustees unanimously approved the use of the calendar year Phoenix-Mesa CPI-U to determine the cost of living allowance (COLA) for retirees.  The first of the new COLA's will be paid in FY 2019.  More detail about this is in this post from earlier this month.  The relevant statutory language about COLA's is:
A retired member or a survivor of a retired member shall receive annually a cost-of-living adjustment in the base benefit based on the average annual percentage change in the metropolitan Phoenix-Mesa consumer price index published by the United States department of labor, bureau of labor statistics, with the immediately preceding year as the base year for making the determination ....
The gist of this is that retirees will be getting a 2.0% COLA starting July 2018.  The average inflation rate in the 2017 calendar year was 2.5%, 2.2% in the first half of 2017 and 2.7% in the second half.  Starting this year, inflation numbers will be provided every two months, instead of just twice a year, which means average inflation calculation will be based on six rates, not just two.  The first of these two-month rates will come out in about two weeks.  The meeting materials from January 2018 showed the average inflation rates for Phoenix-Mesa from 2004 to 2017.  For a PSPRS member who retired in 2003 with a $3,000 monthly benefit, this is the difference between actual average inflation and the new COLA benefit:

               Average               Actual                   New
Year       Inflation               Cost       COLA     Benefit
2004       1.8%                     $3,054   1.8%      $3,054
2005       2.9%                     $3,143   2.0%      $3,115
2006       3.0%                     $3,237   2.0%      $3,177
2007       3.4%                     $3,347   2.0%      $3,241
2008       3.5%                     $3,464   2.0%      $3,306
2009       -1.4%                    $3,416   0.0%      $3,306
2010       0.6%                     $3,436   0.6%      $3,326
2011       2.8%                     $3,532   2.0%      $3,392
2012       2.2%                     $3,610   2.0%      $3,460
2013       1.3%                     $3,657   1.3%      $3,505
2014       1.6%                     $3,715   1.6%      $3,561
2015       0.2%                     $3,723   0.2%      $3,568
2016       1.6%                     $3,782   1.6%      $3,625
2017       2.5%                     $3,877   2.0%      $3,698

Over the 14 years since the member's retirement, the monthly loss of purchasing power would have been $179 or $2,148 annually.  This retiree would only be able to purchase about 96% of what he could in 2003.  This is not insignificant, especially if one is living on a fixed income.  If we eliminate the one year of deflation in 2009 and replace it with 0% inflation, the monthly loss goes up $55 to $234 and the annual total to $2,811, leaving the retiree only able to buy 94.5% of what he could in 2003.  In the 14 years, we have seven years with inflation under 2%, including one year of deflation, and seven years of inflation over 2%.  Outside of deflation or perpetual 2% inflation, retirees will always end up losing purchasing power over time.

If we project out another six years for this hypothetical PSPRS retiree using the current 2.5% annual inflation for 2018 through 2023, after 20 years in retirement the retiree will have lost about 7.5% of the value of his retirement.  If inflation is 3% over that same six-year period, the loss will be 10%.  Your guess is as good as mine as to what extent the recent market volatility has been driven by fears of higher inflation, but the prospect of higher inflation is certainly concerning if you are already retired.

This is again a reminder to those still working to fund another source of retirement income and not rely solely on your PSPRS pension.  If inflation does take off, it only benefits debtors like PSPRS, which can pay retirees benefits that will decrease in value over time, while it takes advantage of the rising rates of less risky investments like US Treasury and high-grade corporate bonds.  As recently as 2000, anyone could invest in a six-month certificate of deposit (CD) earning 5% a year at a time when the US inflation rate was 3.4%.  With inflation at this level, a PSPRS benefit would lose value every year, and it is critical to have some other retirement savings that can benefit from risk-free instruments like CD's to maintain a lifestyle.

As for current retirees, what options do they have?  Unlike the ASRS Board of Trustees, where one of the seven seats is held by a retiree representative, they have no representation on the PSPRS Board of Trustees, where four of the nine seats are filled by active PSPRS members.  The cost of the new COLA system is also included in the annual contribution rate that is split 50/50 between employers and Tier 3 employees (those hired in FY 2018 or later).  These Tier 3 employees (whose COLA will be determined on a sliding scale, based on PSPRS' funded level) are already getting a less generous, more restrictive COLA than Tier 1 and 2 members.  Why would they push for higher COLA's for current retirees when this will eat into their wages, especially after the previous generation shafted them?  They are more likely to push for more non-PSPRS retirement enhancements like matching contributions to their deferred contribution accounts.  Tier 3 members will likely become the majority of active members within 10-12 years.

This situation was brought to us by the blue falcons in the leadership of the Professional Fire Fighters of Arizona (PFFA) and, to a lesser extent, the state law enforcement unions, who played Sancho Panza to the PFFA in this matter.  Not content with just selling out existing retirees and future public safety workers, they set the precedent of altering contractually-bound pension benefits via referendum through their support of Proposition 124.  This will come back to haunt all PSPRS members if there is another pension crisis in Arizona, especially when we have been "led" by people like PFFA President Bryan Jeffries who told the New York Times, public safety members "should volunteer to cut their own pension benefits" during a financial crisis.  However, the final deal he and others brokered with the Arizona Legislature did clarify that he didn't mean his generation of public safety members should sacrifice any benefits, just those that came before and after him.

* 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.  Returns, gross of fees, are used in the table for consistency.  The past two years fees have reduced the final annual reported return by about a half percent.  Returns, net of fees, were 13.28% in FY 2014, 3.68% in FY 2015, 0.63% in FY 2016, and 11.85% in FY 2017.