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

Trustees,

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.