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

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

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

Fiscal Year End	PSPRS Rate of Return	PSPRS Funding Level	Excess Earnings COLA	PFFA 2% COLA Formula	SB 1609 COLA Formula
1998	22.23%	116.3%	$        81.95	$      40.98	$    81.95
1999	17.70%	120.3%	$        87.37	$      43.69	$    87.37
2000	12.31%	124.7%	$        93.24	$      46.62	$    93.24
2001	6.02%	126.9%	$        98.17	$      49.09	$          -
2002	-15.00%	113.0%	$      102.53	$      51.27	$          -
2003	6.70%	100.9%	$      111.90	$      55.95	$          -
2004	14.97%	92.4%	$      116.82	$      58.41	$  116.82
2005	9.11%	83.2%	$      121.76	$      60.88	$          -
2006	8.30%	77.6%	$      127.06	$      63.53	$          -
2007	17.06%	66.4%	$      134.34	$      67.17	$    83.96
2008	-7.27%	66.5%	$      138.66	$      69.33	$          -
2009	-17.72%	68.2%	$      146.74	$      73.37	$          -
2010	13.47%	65.8%	$      152.84	$      76.42	$    95.53
2011	17.37%	61.9%	$      159.13	$      79.57	$    79.57
2012*	-0.79%	58.6%	$      121.19	$      87.47	$          -
2013*	10.64%	57.1%	$        65.20	$      87.65	$          -
2014	13.20%	49.2%
Total			$   1,858.90	$ 1,011.38	$  638.43

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

Before we go further, here is a description of each COLA formula:

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

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

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

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

Total                         $ 941.36     

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

Year	%	COLA	Benefit
1982	7.40%	$   151.70	$  2,201.70
1983	3.50%	$     77.06	$  2,278.76
1984	3.50%	$     79.76	$  2,358.52
1985	3.10%	$     73.11	$  2,431.63
1986	1.30%	$     31.61	$  2,463.24
1987	4.20%	$   103.46	$  2,566.70
1988	4.00%	$   102.67	$  2,669.37
1989	4.70%	$   125.46	$  2,794.83
1990	5.40%	$   150.92	$  2,945.75
1991	3.70%	$   108.99	$  3,054.74
1992	3.00%	$     91.64	$  3,146.38
1993	2.60%	$     81.81	$  3,228.19
1994	2.80%	$     90.39	$  3,318.58
1995	2.60%	$     86.28	$  3,404.86
1996	2.90%	$     98.74	$  3,503.60
1997	2.10%	$     73.58	$  3,577.18
Total		$1,527.18

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

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

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

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

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

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

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

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