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

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

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

Here are the major points of the Task Force's plan:

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

Let's start with the good parts of the Task Force's plan:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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