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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...

Sunday, September 24, 2017

The continuing tragedy of PSPRS' investment returns

The following table shows PSPRS' investment returns, gross of fees*, versus the Russell 3000 through June 2017, the final month of the current fiscal year (FY), with the FY end 2014, 2015, and 2016 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%

7/31/2016 1.62% 1.62% 3.97% 3.97%
8/30/2016 1.76% 3.40% 0.26% 4.23%
9/30/2016 0.71% 4.14% 0.16% 4.40%
10/31/2016 -0.27% 3.86% -2.16% 2.14%
11/30/2016 1.17% 5.07% 4.48% 6.71%
12/31/2016 1.30% 6.43% 1.95% 8.79%
1/31/2017 1.03% 7.52% 1.88% 10.84%
2/28/2017 1.17% 8.78% 3.72% 14.96%
3/31/2017 1.06% 9.93% 0.07% 15.04%
4/30/2017 0.75% 10.76% 1.06% 16.26%
5/31/2017 1.33% 12.24% 1.02% 17.45%
6/30/2017 0.22% 12.48% 0.90% 18.51%

There is usually about a two-month lag in PSPRS reporting its investment returns.  PSPRS' August 2017 Board of Trustees meeting included returns from both May and June 2017 because PSPRS did not have a meeting in July 2017.

PSPRS' FY 2017 return, net of fees, was 11.85%.  For comparison, PSPRS' own Cancer Insurance Plan (CIP) earned 10.12%, net of fees.  The CIP is a simple mix of approximately 25% US equity, 25% non-US equity, 30% fixed income, 10% inflation-linked bonds, 5% commodities, and 5% short-term investments.  The Arizona State Retirement System (ASRS) has not given its FY 2017 returns yet, but an Arizona Republic article from July 19, 2017 stated that it will be around 13.6%, net of fees.  We should keep in mind, though, that this same article also said that PSPRS' FY 2017 returns, net of fees, were going to be 12.5%, so the ASRS estimate might be inaccurate as well.

PSPRS is already crowing about the FY 2017 return and are again using their own particular data set to make their returns look like something special.  However, if we go here to ASRS' page on its rates of return, we can see PSPRS' true mediocrity in comparison to ASRS.  The numbers presented by ASRS do not even do ASRS justice as they do not include the most recent FY return of 13.6%, and yet ASRS still beats PSPRS by 2% (6% to 4%) in the 10-year annualized rate.  On a $9 billion fund, the additional 2% annualized returns over 10 years would generate nearly $2 billion in additional earnings.  PSPRS also lags the CIP by 1.40% in the 10-year annualized rate.

Even more telling is ASRS' historic rates of return, which go back over 35 years.  This is data, by the way, that PSPRS conspicuously does not provide on their webpage.  I suspect that this is because similar PSPRS data would make past PSPRS Administrator Jim Cross look too good in comparison to the succession of mediocrities that have run PSPRS since his departure.  Mr. Cross is the favorite scapegoat of PSPRS' current administration and Board of Trustees, as well as state union leaders, because of some bad investment choices he made during the dot.com bust, but these same people conveniently fail to mention the years of stellar returns he produced prior to those last couple of years of his career as PSPRS Administrator.  I believe that his good years were just in line with the overall markets at the time and not the sign of any particular investing acumen, but it is unfair to look at only his last couple of bad years and give him credit for his prosperous years.

ASRS' historic rates of return show that in 37 years, dating back to FY 1981, ASRS had only five years of negative returns.  One negative year was way back in FY 1984 (-5.2%).  The other four were in FY 2001 (-6.7%), FY 2002 (-8.2%), FY 2008 (-7.6%), and FY 2009 (-18.1%), and we all know what happened during those years.  During that same period, PSPRS had negative returns in eight years in FY's 1984 (-2.45%), 1988 (-1.10%), 1994 (-0.71%), 2001 (-16.86%), 2002 (-15.07%), 2008 (-7.27%), 2009 (-17.72%), and 2012 (-0.79%).  This PSPRS data had to be gleaned from annual reports and is not openly available like it is on ASRS' webpage.

We can see that PSPRS had losses that were nearly double what ASRS had during the dot.com bust.  This makes sense because of the individual stock investment strategy that was being followed at that time by Mr. Cross.  An index-based approach would not have produced such large losses, though some type of market crash was unavoidable when the internet bubble finally popped.  During the Great Recession ASRS' and PSPRS' losses are not much different with ASRS' losses only about 33 basis points greater than PSPRS' losses.  This is because that crisis was systemic and took down everything.  It would not have mattered where one was invested, except strictly in cash or in Big Short-type bets on the housing crash.  You were going to suffer some type of loss.  There was virtually no way to avoid that. 

The point here is that we now have the brain trust at PSPRS trying to develop a strategy for two recent past events that were either caused and/or exacerbated by bad policy (i.e. stock picking during a bubble) or major market downturns (i.e. an investment bubble popping and/or a global liquidity crisis).  This is why they continually highlight data about how the current portfolio would have done in the past during specific crises, but, of course, anyone could retroactively design a better strategy when they know what the markets actually did.  Bad investment policies are easy to deal with by simply getting rid of them, but what about market crashes?

PSPRS is selling the idea that they have found a strategy for mitigating market crashes with its Modern Pension Diversification, but the strategy has yet to be put to the test in an actual market downturn.  Even if we buy into PSPRS' theory, there is the other side of the coin: how much would PSPRS have foregone in higher returns during the past had it utilized this investment strategy? PSPRS, of course, do not provide this information, and we are left with an incomplete picture, as if PSPRS' only goal was to mitigate the effects of market downturns.

The goal for PSPRS should be to produce steady gains over the long term.  ASRS has done this over the past 37 years, absorbing losses during the inevitable market downturns but more than making the losses during the subsequent bull markets.  This has been a success for ASRS, and if PSPRS wants to implement an effective investment strategy all they need to do is study and mimic what ASRS has done.  Or better yet, place PSPRS' investment portfolio in the hands of ASRS.

What is even more unsettling is that PSPRS does not see the policy pitfalls in its own strategy.  By my count, PSPRS has 74 private equity investments, 53 real asset investments, and 39 real estate investments listed its 2016 Consolidated Annual Financial Report (CAFR).  This compares to only a total of 22 US and non-US equity investments listed.  At what point does their strategy become just another form of individual asset picking, especially with private equity (PE), which makes up about 14% of  PSPRS' total portfolio?  While I do not know exactly how PSPRS may be invested with each PE firm, we can see that the PE firms themselves have a multitude of investments.  Just looking at the first three PE firms listed in the CAFR, Abry Partners, Avalon Ventures, Baring PE Asia, we can see each has numerous companies in their PE portfolios.  So you have PSPRS picking dozens of PE firms which each have dozens of companies in their portfolios.  What will happen to all these companies, and PSPRS's stake in them, if there is another market crash?

It has never made sense for PSPRS to invest separately from ASRS, just based on economies of scale alone, and when PSPRS decided last decade to move away from one-man rule over its investment portfolio, its Board should have looked to the established, proven team that had already been successfully running ASRS to take over its investments, or at the very least, for guidance in getting PSPRS back on track.  Instead of PSPRS turning things around after 15 years, we still have second-raters like Jared Smout, Ryan Parham, and Brian Tobin whining and making excuses about PSPRS' failings in both its management and investment performance.  What a tragedy it is that PSPRS, which is not even five miles distant from ASRS, was so incompetently led down such a different and broken financial road, a road from which there seems no exit.

* 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.

Friday, September 22, 2017

The end is near! Final interest rates have been decided in Parker v. PSPRS

The end is nigh for Parker v. PSPRS.  Here is the latest minute entry in the case from September 20, 2017 says:
The plaintiffs in the Hall case have decided not to appeal the trial court’s ruling regarding prejudgment interest.  Phoenix Law Enforcement Association (PLEA) has also decided to abide by the same prejudgment interest rate.  PSPRS has already paid members for the permanent benefit increases (PBI), except to the few members who are deceased.  PSPRS is also working with each employer to return the excess contributions to their employees.  There are many employers, each with its own issues.  The parties will be discussing whether the issuance of a declaratory judgment will be sufficient to resolve the case.
IT IS ORDERED setting a Telephonic Status Conference regarding case status on January 22, 2018 at 9:00 a.m. (time allotted: 15 minutes) in this Division . . .
PLEA had asked the judge in this case to consider an interest rate separate from what was awarded in Hall, but it appears that this was not going to happen and they have dropped this request.  PLEA may have also been hoping that the plaintiffs in Hall were going to challenge the rate in their case and piggy-backed onto that challenge, but that did not come to pass.  So it looks like litigation over SB 1609 is finally over for PSPRS members.

The final interest rates set in Hall were 4.25% pre-judgment and 5.25% post-judgment.  You can read more about in this notice dated July 18, 2017 on PSPRS' website.  Pre-judgment interest will come from employers, just like the excess contributions refunds did, and they will again be allowed to credit the interest payments against their current employer contributions.  Post-judgment interest will have to come from employers' own funds.

The final rates set in Hall were from a court decision dated June 8, 2017.  The cutoff date that separated the pre- and post-judgment periods was June 28, 2017.  It appears that there are still some legal procedures that need to be completed for a formal judgment to be lodged in Parker, but it appears that this should go through unchallenged.  If the same timeframe is followed as it was in Hall, we should see a cutoff date in Parker  of somewhere around October 10, 2017.  The post-judgment period does not go all the way back to the Supreme Court decision.  While I cannot say for certain, I would assume that all excess contribution refunds have been completed by employers, which means the only possible post-judgment interest payment that could accrue would be on any delayed pre-judgment interest payments.  I do not see any reason why employers would delay these interest payments if they can just credit them against their current contributions.

As we have discussed in the past, 4.25% is low and does not represent what PSPRS actually earned on members' money they never should have possessed in the first place.  The Supreme Court decision in Hall came down just after the 2016 election, and we know how much the markets have gone up since then.  In the end, the Duke brothers carry on in spirit within the ranks of PSPRS management and Board of Trustees.  If you want to see some speculation of what the interest payment might be, this post may interest you.

Thursday, August 17, 2017

How the House Ad Hoc Committee on PSPRS can begin fixing PSPRS (UPDATED)

***I have updated this post to correct an error about how contributions will be determined for Tier 3 members.  I have used strikethroughs for incorrect parts and italicized the corrected passages.  I apologize for these errors.***

In the last post, I made the suggestion to the House Ad Hoc Committee on PSPRS (“the Committee”) that they use their influence to press for the removal of PSPRS Administrator Jared Smout.  While this would be an overdue and important change, long-term it will have minimal effect on PSPRS, and long-term fixes are what the Committee is trying to find.

In Craig Harris’ article, “Arizona mayors call on Ducey to push overhaul of financially fragile public-safety pension system,” from the July 19, 2017 Arizona Republic, two reform ideas mentioned by State Senator Noel Campbell, Bisbee Mayor David Smith, and Prescott Mayor Harry Oberg were “the abolition of the PSPRS board and management, and . . . placing the fund's operation under the state treasurer,” and “ask voters to amend the state Constitution, which now dictates that a pension benefit given to a public employee cannot subsequently be taken away.”

The first idea could be accomplished more simply by changing the makeup of the Board of Trustees so that it was more representative of employers and taxpayers.  As far as I know, the Arizona legislature can staff the Board in any way it sees fit.  It is up to them to decide if employee representatives need to be voting members of the Board or what value and expertise firefighters and law enforcement officers contribute in the fields of actuarial science, finance, and investing.  PSPRS has four active members, two fire and two law enforcement, on its nine-person Board.  If this is excessive, they can change it.  There is no need to turn over the management of PSPRS to the Treasurer, just create a Board that knows what it is doing, and have these individuals hire a competent Administrator and other staff.

As to the second proposal, repealing or altering Article 29 of the Arizona Constitution, which prohibits the diminishment or impairment of pension benefits, would not affect the unfunded liabilities that already plague employers.  The excess contributions portion of the Hall case was decided in favor of the plaintiffs on the basis of case law (Yeazell) and did not rely on Article 29.  The contribution rate was deemed a binding contract between employees and employers that could not be changed unilaterally in favor of the employers.  Existing pension benefits also constitute a binding contract.  [Oddly, 2016’s PSPRS reform used Article 29 to accomplish the very thing it was meant to prevent.  Proposition 124 used a voter-approved amendment to Article 29 of the Arizona Constitution to eliminate the contractual and heretofore constitutionally protected permanent benefit increase (PBI) and replace it with a capped 2% cost of living allowance (COLA).]  Any change in benefits would still have to contend with case law, and most likely, the contract clauses of the Arizona and United States Constitutions, so repealing Article 29 is not the solution to the unfunded liabilities that already exist.

Currently, it seems virtually impossible to decrease any existing pension benefit, except through constitutional amendment (assuming Proposition 124 was constitutional) or the bankruptcy of an employer.  Any changes to PSPRS have to be prospective, affecting only those yet to be hired, administrative, or in line with existing pension benefits.  If the House Ad Hoc Committee on PSPRS wants to make some administrative, here are some suggestions:
Amend Article 29 of the Arizona Constitution to mandate equal contributions toward normal costs "the normal costs and the actuarially determined amount required to amortize the total unfunded accrued liability within the public safety pool" from employers and employees in any state pension that already has this requirement and for all future hires.  This is one of the most important changes that state legislators could make.  This would make cost sharing of normal costs all costs permanent and immutable.  The long game played by the state public safety union has always been to continually push for new or enhanced benefits like the PBI and DROP because the unions knew they were protected from any financial consequences by a fixed employee contribution rate.  This meant that no matter how costly the benefit became, it would never affect employees.  The cost would be borne by employers and taxpayers.  Splitting normal all costs would force any financial costs to fall equally on employers and employees and eliminate the perverse incentive state public safety unions have to push for unfunded enhancements of their pension benefits.  If the unions want to convince Arizona’s House and Senate to create a new or enhanced benefit, they will have to pay their fair share for it.

This amendment should not be controversial.  The state public safety unions already agreed to this condition for Tier 3 PSPRS members, and the Arizona State Retirement System (ASRS) and Corrections Officer Retirement Plan (CORP) already split normal all costs.  The Elected Officials’ Retirement (EORP) no longer has a defined benefit plan for new members.  Because of the Hall decision, nothing can be done about those PSPRS, EORP, and CORP members grandfathered into their respective systems with a fixed employee contribution rate.  This amendment would be simple to write and understand, and hopefully, the state’s voters would overwhelmingly approve.

Allow another state government entity to choose PSPRS’ actuaries, accountants, and outside investment consultants.  This goes hand-in-hand with the previous idea.  A neutral, objective party must give all stakeholders a realistic assessment of PSPRS’ financial condition.  As was seen with accounting firms and bond rating agencies, problems can arise when the organization being scrutinized is the one paying the company scrutinizing it.  I suspect it is only a matter of time before some major actuarial firm is sued for malpractice over a public pension that fails.

The Treasurer or Auditor General should set the engagement standards, choose, contract with, and pay (out of PSPRS' budget) the actuaries, accountants, and outside investment consultants.  The Treasurer or Auditor General should also receive the actuarial reports and financial statements before PSPRS does so that any problems identified cannot be covered up by PSPRS’ staff or Board of Trustees.  In Mr. Harris’ article, PSPRS Board of Trustees Chairman Brian Tobin boasts, “. . . that he has supported since 2011 legislation that would reform cost-of-living adjustments for retirees and have employees make higher contributions for their pensions.”  That’s the kind of bold, determined spirit you get from someone who will get nearly $1 million dollars his first year of retirement.  The funny thing is that page 8 of the Arizona League of Cities and Towns’ Pension Task Force Report says this:
. . . prior to FY 2015-16, the cost of the PBI 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.
Keep in mind that Brian Tobin became Chairman of the PSPRS Board of Trustees sometime during fiscal year 2010.  He knew the PBI was a problem, yet in his official capacity as the Chairman, he did not require PSPRS to account for it in the normal cost, despite being informed of this problem by PSPRS’ own actuary.  This alone would argue for Mr. Tobin’s removal from the Board, and it is further evidence of Jared Smout’s unfitness to be PSPRS’ administrator.  What a duo we have leading PSPRS.

If the Arizona Treasurer or Auditor General had received a report from an actuary saying that PSPRS had, for years, not been accounting for a major driver of PSPRS’ underfunding, I think the problem would have been addressed much sooner and those responsible for this “oversight” would no longer be working at PSPRS.  As we see in this case, even when we have an ethical actuary raising a red flag, we still cannot trust PSPRS to take the proper action to address it.  With normal costs now split evenly between employees and employers, there will be even more incentive to lowball normal costs, as any normal costs not properly accounted in the present will appear later as unfunded liabilities.  Unfunded liabilities will be the sole responsibility of employers and taxpayers.  For the sake of Tier 3 members and employers who will have to foot the bill for any of PSRPS' chicanery, this is why someone other than PSPRS must choose its actuary, accountants, and investment consultants.

Subject PSPRS to a more comprehensive analysis of its investments, fees, and how PSPRS' investment strategy compares with those of other funds.  This report, of course, would have to be produced by an outside entity hired by another state agency.  The Panglossian world of the PSPRS office is one where whether PSPRS makes money, loses money, or underperforms, it is always doing great.  PSPRS is always in some top segment of some subset of funds, but it underperforms its own Cancer Insurance Plan and ASRS.  What of all its investments in private equity and real estate?  These are notoriously hard to value.  What methodology is used to value these?  Furthermore, as of last fiscal year, PSPRS had, by my count, 74 private equity investments, but only 11 of these investments accounted for 83% of its gain in its private equity portfolio.  It is great that this asset class is earning good (paper) returns, but how is this different than picking individual stocks.  When your portfolio gets big enough, when do your picks become luck rather than any display of skill?  What would PSPRS have done if it had used other strategies, paid lower fees, or simply invested in the S&P 500 since 2000?  We already know we cannot trust Mr. Tobin or Mr. Smout to accurately account for normal all costs.  Why would we trust them to provide accurate investment figures or assessments?

The Arizona Legislature must get other political subdivisions involved in any penson benefit legislation they pass in the future.   The legislature and state public safety unions have always negotiated pension benefits over the heads of the cities, towns, counties, fire districts, and tribal nations who have to pay for them.  These groups must get a seat at the table whenever changes in benefits are considered.  Outside of the Department of Public Safety, the state has no large employee group in PSPRS, and the state has much deeper pockets than other political subdivisions.  Unfortunately, I am not sure of a way that this can be mandated
I personally think that the Legislature should not determine PSPRS benefits.  They farmed out negotiations for 2016’s pension reform to Reason Foundation, a private, public policy research group, so I don’t know why they don’t allow the Arizona League of Cities and Towns or some other group acceptable to the political subdivisions to negotiate with the state public safety unions.  I suppose the League could also use Reason Foundation as a consultant to help them out.  The political subdivisions and the unions are the two parties most affected by pension legislation, and they should be able to come to some agreement about what is best for both of them.  This is routine business at the local level w here these groups negotiate over wages and benefits.  The Legislature has to realize by now that the status quo cannot continue, and political subdivisions must have some part in determining pension benefits.  This is what Mayors Oberg and Smith should really be advocating for if they want to stop the pension debt monster from coming back to ravage their cities in 25 or 30 years.
The bottom line is that too many elements inside and outside of PSPRS have been allowed to run unchecked for too many years.  While it appears that nothing can be done about pension benefits already promised, these are some easy, non-litigatable steps to rein in those who cannot control their own myopia, greed, selfishness, and stupidity.

Saturday, August 12, 2017

Out with Smout: It's time to get rid of PSPRS Administrator Jared Smout

I hope most PSPRS members have read this article, "Pension executive defends six-figure retirement payouts for police, firefighters," by Craig Harris in the August 10, 2017 Arizona Republic.  If not, please take the time to read it because it goes a long way in showing why PSPRS is in the mess it is today.

The pension executive to whom the article is referring is PSPRS Administrator Jared Smout. What he was shamelessly defending before the Arizona House Ad Hoc Committee on PSPRS was the Deferred Retirement Option Plan (DROP).  Keep in mind that Mr. Smout is the person in charge of PSPRS, not a spokesperson or a self-interested individual like PSPRS Board of Trustees Chairman Brian Tobin, a man who will get nearly $1 million in pension and DROP payments during his first year of retirement.  The one individual from whom we should expect an honest appraisal is the  PSPRS Adminstrator.

I have had the misfortune of hearing Mr. Smout speak publicly.  If you did not believe that someone could be both arrogant and banal, go see Mr. Smout speak.  If you ever saw former Federal Reserve Chairman Alan Greenspan speak before Congress, you will get a sense of Mr. Smout's style of delivery.  Of course, this is the only similarity between those men--Alan Greenspan has a much more varied and accomplished background than PSPRS lifer Jared Smout, but perhaps Mr. Smout thinks that if he talks like Mr. Greenspan, his words will be accorded the same gravity and credibility.  Why else would he say that "there was a perception problem with the Deferred Retirement Option Plan — or DROP — and that it was a "myth" that the program has cost the pension trust a 'huge' amount of money" unless he thought the Committee would just believe him out of hand because he speaks his  financial jargon in such a condescending tone.

Mr. Smout has to be ignorant, incompetent, and/or deceitful to make a statement like that in front of a congressional committee.  The DROP is indefensible.  It was a blatant money grab from the pension perpetrated during a brief period when PSPRS was overfunded.  Among problems with the DROP are:
  1. For many years it paid a guaranteed interest rate of up to 9%, even when PSPRS was losing money. 
  2. It robs PSPRS of funding.  A pension relies on a constant stream of funding to stay solvent.  These funds must compound over time, and if the actuarials are correct, a BIG if, the pension can stay solvent in perpetuity.  The DROP interrupts this funding stream.  If five members all DROP for the full five years at 25 years of service , the pension will lose 25 years of funding from employees who are likely to be at their highest pay.  That's an entire career of payments into the pension that will never be paid.
  3. It slows the replacement of higher paid Tier 1 employees with Tier 3 employees.
In case Mr. Smout truly is ignorant, let's explain it to him as simply as possible: An employee cannot be active and retired at the same time.  This is common sense.  You can either have a longer career and get a higher pension for fewer years or you can have a shorter career and have a smaller pension for more years.  This is Pensions 101.  This is why no other retirement systems allow the DROP, with the exception of other well-managed public safety pensions like the Dallas Police and Fire Pension Plan.  PSPRS' own policy states that "at ANY time following retirement, if you are re-employed in the same, or substantially similar position by the employer from which you retired, your retirement benefits will be suspended."  This policy prevents employers from hiring back their own public safety retirees, at a lower cost as they would no longer have to pay pension contributions for these employees, in place of new employees for whom contributions would have to be paid.  The obvious reason for this policy is to prevent employers from starving PSPRS of the consistent funding stream it needs to stay financially viable.  This PSPRS policy prevents an employer from doing the very thing the DROP permits.  Yet, Mr. Smout defends the DROP and says that "his organization concluded it was largely cost-neutral."

I know nothing of Arizona State Senator Noel Campbell's background, but he seems to understand the DROP better than Mr. Smout.  Mr. Harris writes:
Campbell also said he didn't believe Smout's assertion about DROP's cost. The lawmaker said his examination of PSPRS records suggested DROP is "a very expensive drain on the fund," and he believes the benefit should be terminated for all current employees.
Campbell also characterized DROP's guaranteed rate of return as too generous, noting it would be nearly impossible to find in the private sector. He said DROP prevents local governments from hiring new, less costly employees to replace "retired" officers in DROP for five years. Unlike many officers in DROP, those new employees also would be making individual contributions to the retirement system.
Senator Campbell does not believe Mr. Smout, and neither should anyone else.  If there are still any defenders of the DROP, PSPRS, or Mr. Smout, here is more from Mr. Harris' article:
. . . the Arizona State Retirement System, which is in better financial health, ended DROP because of major cost concerns.
Paul Matson, chief executive of the ASRS since 2003, said in an earlier interview that the ASRS, the much larger pension system, never implemented DROP because it would have significantly increased trust payments for members and their government employers. 
Matson had lawmakers revoke DROP for ASRS members in 2006.
"We didn't implement it because we didn't want contribution rates to increase," Matson said. 
The ASRS trust is in better financial health than the PSPRS. The pension system for teachers and state and local government employees has a funded ratio of 76 percent, meaning it has about three-fourths of the money it needs to pay all current and future liabilities.
ASRS is 76% funded.  PSPRS is about 47% funded.  ASRS has a contribution rate of 11.50% apiece for employers and employees.  PSPRS has an aggregate employer contribution rate of 52%, with much higher employer contribution rates for some employers.   ASRS has needed only limited adjustments, while PSPRS is continually in need of major reforms.  Paul Matson, who has worked for ASRS since 1995 and been its Executive Director since 2003, says that the DROP is a bad policy that would have caused contribution rates to increase for ASRS employees and employers, and he had it revoked in 2006 well before the financial downturn of 2008-09.  Mr. Smout says the DROP is just fine and dandy.  Should you believe Mr. Matson or Mr. Smout about the DROP? 

One man works proactively to reverse a harmful policy to the benefit of all stakeholders.  Another man continues to defend an obviously deleterious policy that benefits only one group of employees at the expense of all other stakeholders.  Sadly, what stands out most in this article is the utter cravenness of Mr. Smout.  His statement before the committee was his chance to do the right thing and, at the very least, admit that the DROP was a costly error on the part of Arizona's legislature.  As an administrator, he was not responsible for the statute that created the DROP, but
I would say he has a responsibility to speak the truth when a state law is enacted that negatively affects the system he administers.  Mr. Matson did.  Why wouldn't Mr. Smout do the same?

I suppose Mr. Smout is lucky to still be employed by PSPRS, much less working as its Administrator.  When former Administrator James Hacking was caught giving illegal raises to some PSPRS employees, Mr. Smout, the Deputy Administrator at the time, turned out to be the person who authorized payroll to process the illegal raises.  Mr. Hacking agreed to resign after negotiations with the Board of Trustees, but Mr. Smout remained with PSPRS and was eventually tapped to lead it.  It would seem that the Deputy Administrator should have known that what he was authorizing was illegal and should have taken a stand against it.  However, he did not and, in the end, this act actually helped to move Mr. Smout up the PSPRS ladder.  I guess Million Dollar Man Brian Tobin and the other Trustees saw something in Mr. Smout's weak-willed behavior during that episode that made them think he was the best person to run PSPRS for them. 

If the House Ad Hoc Committee on PSPRS wants to begin the process of administrative reform at PSPRS, they should press for the removal of Jared Smout as PSPRS Administrator.  A man with neither the will nor the backbone to do what is right should not have the future of so many hard-working people in his hand.

Tuesday, July 18, 2017

Final interest rates for the Hall case: 4.25% for pre-judgment interest; 5.25% for post-judgment interest

This information about the Hall case came out this afternoon

PSPRS was informed last week that the Hall lawsuit impacting Tier 1 EORP members has finally come to a conclusion. As such, prejudgment interest was awarded at 4.25% up through June 28, 2017. Those interest amounts have been calculated and updated to the Employer and Local Board portals today. As a reminder, the prejudgment interest amounts will be included in the credit amounts available for employer use.  These individual amounts will be available in the Members Only portal within the coming days.
The post-judgment interest rate has been determined to be 5.25% where each employer will need to calculate those individual amounts. As a reminder, the post-judgment interest amounts will not be included in the credits available to employers.
To calculate the post-judgment interest, you may use the following formula:
Post-judgment Interest Amount = Total of Contributions and Pre-judgment Interest x .0525 x Number of Days Between June 29 and Payout /365 
This should be calculated on an individual basis for each of your members. Also, this formula assumes you will pay out the contributions and the interest on the same day. If you are planning to pay them out separately, then apply the same formula to the separate amounts (the only difference will be the entry for the “number of days between June 29 and payout.")

Now that the Hall case is officially over, the courts have begun to address the Parker case for PSPRS members. While the remedies will be similar as to the statutory reference for the amount of interest, the actual rate applied to pre-judgment interest could be different. Therefore, we appreciate your patience as this case is adjudicated to completion.
Before I comment further, I need to see an actual pre-judgment interest calculation as I do not know how they will apply this rate to the excess contributions.  4.25% seems low to me, and it appears that they used the prime rate in effect at the time SB 1609 was implemented in 2011 (3.25%) and added 1%.  The current prime rate is 4.25%.  I checked my own PSPRS account and found no pre-judgment interest total displayed, but PSPRS is updating its member portal and does not appear to be posting any new information there.  The new member portal is supposed to go live on July 21, 2017, but it has already missed a previous deadline.  While I suspect that PSPRS members are being cheated, I need to see more information first.

Thursday, July 13, 2017

The lastest in Parker v. PSPRS: The prejudgment interest rate has still not been determined

Here is the latest from the July 12, 2017 status conference in Parker v. PSPRS:
The parties previously agreed to abide by the decisions in the Hall and Fields cases.  The Court is advised that the trial court in the Hall case has ruled on what prejudgment interest rate to apply and entered a final judgment.  It is unknown whether the Plaintiffs in the Hall case will be appealing the ruling.  The Phoenix Law Enforcement Association ("PLEA") would like this Court to independently decide what prejudgment interest rate to apply.  However, PLEA will discuss same with Defense counsel and determine whether it will wait to see if there is an appeal in the Hall case, or file its own motion.
The parties will also work together to draft a stipulated judgment for the Court’s review and approval.
IT IS ORDERED setting a further Telephonic Status Conference on September 20, 2017 at 9:00 a.m. (time allotted: 15 minutes) in this Division, before Honorable Judge Rosa Mroz . . .
If the parties reach an agreement before the Status Conference and would like to the Court to sign the stipulated judgment expeditiously, the parties are encouraged to contact this Division’s judicial assistant . . .to alert her of the filing.
So there is still some discussion over the final interest rate to be applied.  PLEA obviously does not agree with the rate of interest applied in Hall, but they and PSPRS may be able to work something out before the next court date.  This explains the delay in setting a rate and paying interest.  As I have written before, the right and fair thing for PSPRS to do is pay members what it actually earned on the excess contributions.  This rate is likely to be higher than the prime rate + 1% awarded in Hall, but lower than the 10% the Hall plaintiffs wanted.  PSPRS exists to serve members, not use them as a source of income  Earning some profit off the spread between actual returns and the statutorily required prejudgment interest of rate is immoral.  Applying PSPRS' actual rate return as the prejudgment rate seems like a good compromise to me, and it would settle this matter quickly.

There is no mention of PBI's, so it does not appear that Mr. Parker and his fellow plaintiffs will be contesting the constitutionality of Proposition 124. 


A commenter asked what PSPRS' actual rate of return has been and how that translated into actual dollars.  I went back to a spreadsheet I used for this post that estimated prejudgment interest on a $12,000 refund.  I changed it up by using the actual net rates of return for the following fiscal years (FY's):

 Rate of
 FY Return
2012 -0.79%
2013 10.64%
2014 13.28%
2015 3.68%
2016 0.63%
2017* 10.26%

The rate of return for FY 2017 are only through April 2017, which is the latest PSPRS has provided, and a half-percent was subtracted from the gross return to keep it consistent with the net returns for the other FY's.  As before, I divided the annual rate of return by 26 pay periods and ran a running total of the simple interest.

The $12,000 in excess contributions generated $1,420 in simple interest at 5.0% and $1,489 at 5.25%, as of the end of June 2017.  The prime rate at the time of the Hall decision was 4.0%, but it increased to 4.25% several days after the decision.  I do not know which rate will be used if they use prime rate + 1%.  Using PSPRS actual rates of returns generated $2,223 in prejudgment interest, a significant increase of around $735 or $800, depending on which prime rate we use.

Prejudgment interest of $2,223 would produce an annualized rate of 8.1% going back the full six year period to July 2011, so we can see the incentive PSPRS has to keep the rate at the much lower prime rate + 1%.  The spread was higher than I thought it would be, but this is due to the high returns in the current FY, which is when the refund amount was largest.  If PSPRS maintains an annual rate of 10.26%, about $58 will be earned every pay period on the $12,000 refund amount versus only about $24 at 5.25%.

Friday, July 7, 2017

PSPRS investment returns through April 2017

The following table shows PSPRS' investment returns, gross of fees*, versus the Russell 3000 through April 2017, the eighth month of the current fiscal year (FY), with the FY end 2014, 2015, and 2016 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%

7/31/2016 1.62% 1.62% 3.97% 3.97%
8/30/2016 1.76% 3.40% 0.26% 4.23%
9/30/2016 0.71% 4.14% 0.16% 4.40%
10/31/2016 -0.27% 3.86% -2.16% 2.14%
11/30/2016 1.17% 5.07% 4.48% 6.71%
12/31/2016 1.30% 6.43% 1.95% 8.79%
1/31/2017 1.03% 7.52% 1.88% 10.84%
2/28/2017 1.17% 8.78% 3.72% 14.96%
3/31/2017 1.06% 9.93% 0.07% 15.04%
4/30/2017 0.75% 10.76% 1.06% 16.26%

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

This post is more than a little late because of all the Hall case doings that have taken place over the last two months.  Through April 2017, PSPRS is returning about 2/3 of the Russell 3000, which is very good and exceeds the 55-60% range that we have seen in the past.  So kudos to PSPRS through April 2017.  The Russell 3000 ended the fiscal year 2017 with an annual return at just about 18.50%, so if PSPRS gets to 2/3 of that, it would return 12.21% for the fiscal year.  Even at 55-60% of the Russell 3000, it would produce an annual return in the range of 10.18% to 11.10%.  All of these would well exceed the expected rate of return of 7.40%.  PSPRS' Cancer Insurance Plan (CIP) has returned 8.30%, net of fees, through April 2017, so if we subtract 0.50% from PSPRS fiscal YTD returns, PSPRS is surpassing the CIP by almost 2%.

PSPRS has positive returns in all its ten major asset categories and in its short-term investments.  The CIP has positive returns in four of its five major categories, as well as its short-term investments.  The CIP has lost about 1% on its fixed income investments for the fiscal YTD, though PSPRS has returned 4.60% on its fixed income portfolio, a 5.60% difference.  The fiscal YTD returns on US and non-US equity, the only other two categories that the two funds share, showed much smaller differences, a 0.48% return in the CIP's US equity and a 0.75% higher return in the CIP's non-US equity.  Fixed income makes up 26.60% of the CIP's total portfolio, while it makes up only 5.49% of PSPRS' total portfolio.  I am not sure why the CIP would have a different fixed income portfolio than PSPRS, nor do I know if they have different investment managers, and not to rain on PSPRS' parade, but obviously, the CIP's fiscal year to date return would have been much closer to PSPRS' fiscal YTD return if the CIP had invested in the same fixed income portfolio as PSPRS.  This shows an element of luck in choosing investments that underlies all actively managed portfolios.

If PSPRS were to end the year at 12.21% returns, this would mean that under the old PBI system about 1.60% of the fiscal year's returns would be sequestered in the Fund for Future Benefit Increases to be used for PBI's.  PSPRS ended FY 2016 with $8.291 billion in investments; 1.60% of that would be over $132 million available to pay PBI's.  The first COLA under the new system will not be paid until next fiscal year (FY 2019).  Inflation through the 12 months ending May 31, 2017 was 1.9%.

* 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, and 0.63% in FY 2016.

Tuesday, July 4, 2017

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 permanent benefit increase (PBI) formula with the new cost of living allowance (COLA).  This change was put in place by the passage of Proposition 124, the Public Retirement Benefits Amendment, in May 2016.  It amended the Arizona Constitution via referendum to allow a change in a public pension benefit.  This referendum was passed by Arizona voters by a 70-30% margin. 

However, changing a public pension benefit is considered an unconstitutional act in Arizona based on Article 29 of the state constitution, which states “Public retirement system benefits shall not be diminished or impaired . . . “  This was the legal justification for Kenneth Fields' and Philip Hall’s successful challenges to the change in the PBI formulation under the Elected Officials’ Retirement Plan (EORP).  The EORP PBI is a retirement benefit, and it could not be “diminished or impaired” unilaterally by the Arizona legislature under SB 1609.

In order to avoid the same legal problems caused by SB 1609, which was only approved by the legislature, Proposition 124 added the following (italicized) language to Article 29 after a vote by the state’s citizens:
Public retirement system benefits shall not be diminished or impaired, except that certain adjustments to the public safety personnel retirement system may be made as provided in senate bill 1428, as enacted by the fifty-second legislature, second regular session.
This ostensibly allowed the state to “constitutionally” change a public pension benefit, eliminate the PBI formulation for all PSPRS members, and move to a strict COLA for existing retirees and all defined benefit tiers.  Proposition 124 did not affect EORP members, and the Arizona Supreme Court ("the Court") quickly dealt with the PBI issue in one short paragraph in its decision in Hall.  The change was unconstitutional under Article 29, just as it was in Fields, and it did not matter if a member was retired or active.

This is where it gets interesting for PSPRS members.  Outside of Article 29, another argument that was used by plaintiffs in their cases against SB 1609 was that it violated the Contract Clauses of both the Arizona and United States Constitutions.  Since Hall only dealt with EORP, which was not affected by Proposition 124, there was no reason to decide if changing the PBI via referendum violated the Contract Clauses.  The Supreme Court even avoided the consideration of the Contract Clause in its original decision saying:
The dissent also maintains that the Bill’s changes to the Plan may be upheld under the Contract Clauses of the United States and Arizona Constitutions. U.S. Const. art. 1, § 10; Ariz. Const. art. 2, § 25. See infra ¶ 107. As we have explained, however, the Bill’s unilateral and retroactive changes to the vested terms of the Plan violate Yeazell and the Gift Clause. See supra at ¶¶ 19–23. Consequently, analyzing whether the Bill would pass review under the Contract Clauses were it not for Yeazell and the Gift Clause is unnecessary and violates the principle of judicial restraint. See Superintendent, Mass. Corr. Inst. v. Hill, 472 U.S. 445, 453 (1985) (stating that judicial restraint requires “avoid[ing] unnecessary resolution of constitutional issues”).
The Supreme Court was using other guidelines in its decision and was not going to go there when it came to the Contract Clauses.  It even refused to do so in a Motion for Reconsideration filed after its decision.

Before we discuss this further, a little refresher on what exactly was changed by Proposition 124 might be helpful.  The old PBI, which was often incorrectly called a “COLA”, was not based on any measure of inflation.  It worked by taking half of any annual investment earnings over 9% and putting it in a Fund for Future Benefit Increases (“the Fund”).  The money was sequestered and could only be used to pay PBI's.  From the Fund, PBI’s of up to 4% of the average normal retirement could be paid to retirees.  For many years, the Fund had an excess, so PBI’s became a regular and expected annual raise for retirees.  The problem with the PBI formula was that it worked in only one direction.  Whenever PSPRS earned over 9%, money was moved to the Fund, but if PSPRS lost money, nothing went back to PSPRS’ investment pool to help mitigate losses.  If PSPRS lost 10% one year, then earned 10% the next year, 0.50% of the second year’s earnings would still be bled off into the Fund, even though averaged only 0.25% for the two years.  The rough years of the 2000’s showed the ugliness of this system.  While PSPRS became more underfunded every year and employer contribution rates increased, PSPRS was still forced to take much-needed investment earnings and use them to pay PBI’s.

To further illustrate this, we can use the current fiscal year (FY) as an example.  Let's say PSPRS ends the current FY with a 13% annual return.  Under the old PBI system, half of the amount over 9% annual return was required to be transferred to the Fund.  With $9 billion in investments, this would be $180 million taken from PSPRS’ investment pool to be used for PBI’s.  This would be despite the fact that PSPRS is less than half funded and many employers are already straining their budgets to make their annual contributions. 

If we look at the FY 2016 PSPRS annual report, there were 11,863 retirees or survivors, and the average normal retirement was $4,632 per month.  A 4% monthly increase would on the average normal pension would be $185.28.  The cost of this PBI per year would be $26.375 million, leaving over $150 million for PBI’s in future years.  Any future FY’s that achieved returns greater than 9% would continue to add to the Fund, and PBI’s of up to 4% would be paid as long as there was money in the Fund.  This PBI, as the name says, is permanent, not just for that year of excess earnings, so it would have to be paid to all retirees who received it until they or their surviving spouses died.  Remember too that as long as there is money remaining in the Fund, more PBI's could be awarded in future years, compounding the unfunded benefit increases.  Also, as the average normal retirement benefit increased over the years, whether through wage inflation of those still working or via PBI's, future PBI’s would increase as well.  This allowed monthly retirement benefits to steadily increase over the years, especially for those with less-than-average benefits, as their PBI’s were a higher percentage of their monthly benefits as compared to those retirees with average or above-average monthly benefits.

The new COLA system that was put in place with the passage of Proposition 124 is much simpler.  It allows for the payment of an annual COLA that is the lower of 2% or a local consumer price index for the Phoenix area.  The COLA is also paid on an individual’s own retirement, not the average normal benefit, so a retiree cannot see his retirement grow any faster than 2% per year.  If inflation is higher than 2%, retirees will see a loss in earning power that year.  If it less than 2%, they will only get a COLA that matches that annual inflation rate.  If inflation is 1% one year and 5% the next year, the retiree will see his benefit increase by 1% the first year and 2% the next year.  The other 3% of inflation will have to be absorbed by the retiree.  The COLA’s will be paid for in the employer contribution rates in FY 2018, which started July 1, 2017.  The first COLA will not be paid to PSPRS retirees until FY 2019, sometime after July 1, 2018.

So we can see that there is a dramatic difference between the old PBI and new COLA systems.  I would be the last person to defend the old PBI system.  It was a system designed by selfish, shortsighted, and foolish people who thought that PSPRS would never earn less than 9% a year and that high inflation would be a permanent condition in the economy.  They never took in to consideration the compounding effect of this benefit, which anyone with any common sense could have seen would eventually harm the pension.  While not as bad as the PBI system, the new COLA system has its own cabal of selfish, shortsighted, and stupid proponents.  The only difference is that these people think that low inflation and low market returns will be the new normal.  The disgraceful sellouts in the state-level fire and police unions have designed and/or supported a system that will rob retirees of purchasing power in order to bring PSPRS back to financial solvency.  Of course, this is not the subject of this post.  Those who want to read more about what has happened in the reform efforts can look back at older posts. 
Returning to our original topic, I do not know if the plaintiffs in Parker v. PSPRS will challenge the constitutionality of Proposition 124.  They would seem to have a good case under the Contract Clauses of the Arizona and United States Constitutions.  Here is what Article I, Section 10 of the United States Constitution says:
No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts, or grant any Title of Nobility.
I have place in boldface the relevant part about contracts.  Article II, Section 25 of the Arizona Constitution has nearly identical language and says, “No bill of attainder, ex-post-facto law, or law impairing the obligation of a contract, shall ever be enacted.” 

The United States Constitution makes it very clear that no state can void a contract through passage of a law.  The Arizona Constitution specifically prohibits the Arizona Legislature from doing so.  Yet this is exactly what the Arizona Legislature did by passing SB 1428 and referring a constitutional amendment to the ballot.  I am not a constitutional scholar but what the Arizona Legislature did would seem to violate the letter and spirit of the Contract Clauses.  They passed an unconstitutional law then referred it to the voters in order to make it “constitutional” under Article 29, but this still violated the Contract Clauses.

Under this same guise, couldn't the Arizona Legislature have changed our pension in any way they wanted?  All it would take is for them to pass a law and send it to the voters for approval as a constitutional amendment to Article 29 of the Arizona Constitution.  Proposition 124 set the precedent for any abrogation of pension promises as long as the voters approve an amendment to Article 29, but the pension is still a contract between employees and the state pension system.  Can it be this simple to change this contract?  Article 29 of the Arizona Constitution is meant to give additional protection to the pension contract between public employees and their government employers, but does its public pension-centric focus allow for amendments that can actually override the Contract Clauses?  This seems to be what the Arizona Legislature and state public safety union leaderdship believe.

If we look deeper into the Hall decision, the Supreme Court time and time again refers to the plaintiffs as being in a contractual relationship with the State:
Yeazell thus protects the specific terms of a public pension contract from unilateral retroactive alteration. Even the dissent in Yeazell recognized this as the Court’s holding. See id. at 118, 402 P.2d at 547 (Udall, J., dissenting) (stating that the majority’s holding was based on the “erroneous premise that there was created upon employment an absolute binding ‘contract’ to a specific pension,” which meant that the majority was holding that “the legislature, by subsequent enactment, can modify the original pension terms only if the employee consents”).
The Bill’s changes to the Class Members’ pension contracts are consequently invalid under Yeazell. When the Class Members were elected or appointed as judges, they entered a contractual relationship with the State regarding the public retirement system of which they became members. Their retirement benefits were a valuable part of the consideration the State offered upon which the Class Members relied when accepting employment. See Fields, 234 Ariz. at 220 ¶ 27, 320 P.3d at 1166 (“As in Yeazell, Fields has a right in the existing formula by which his benefits are calculated as of the time he began employment and any beneficial modifications made during the course of his employment.”). Under their contracts, the Class Members received retirement benefits as terms of their contracts for which they agreed to share the cost with their employers. Thus, an increase in the Class Members’ proportionate share of the contribution rate above 7% and the change in the statutory formula granting permanent benefit increases without the Class Members’ consent are breaches of that contract and infringe upon the Class Members’ contractual relationship with the StateSee Thurston, 179 Ariz. at 52, 876 P.2d at 548 (“Where the modification is detrimental to the employee, it may not be applied absent the employee’s express acceptance of the modification because it interferes with the employee’s contractual rights.”). By including in its scope Class Members who were Plan members at the time of enactment, the Bill retroactively, unilaterally, and substantially changed the contract terms that the parties previously agreed to. This violates Yeazell.
As can be seen by all the portions I have put in boldface, the sanctity of the contractual relationship between EORP members and the State was considered the crux of the matter by the Court. This was based on the precedent set in the Yeazell v. Copins case, which dates all the way back to 1956.  The Court could easily dismiss the State's arguments for changing EORP's PBI system to a strict COLA by pointing to Article 29, as the post-retirement benefit increase mechanism was very clearly a retirement benefit that cannot be "diminished or impaired."  However, when it came to the increase in employee contribution rates, the Court used the pension contract-centric Yeazell to overturn the State's actions in SB 1609.  The Court reminds us that employees make a decision on whether to accept employment with an Arizona government entity based on the conditions existing at that time.  EORP members are not like Tier 3 PSPRS members who will enter PSPRS knowing that they will not have a fixed contribution rate and must split normal contributions 50/50 with employers during their entire careers.  Tier 3 employees should be aware of this risk when they are offered employment.  If they are not comfortable with this situation, they can either go into a separate defined contribution plan or decline to work for the state agency.

But what about the dire financial state of EORP and PSPRS?  There are certain conditions under which a contract can be changed retroactively.  Here the issue is brought up in the Hall decision:
EORP and the dissent both argue that this is not the end of the analysis. They note that Yeazell commented that if a governmental entity shows that its pension plan is actuarially unsound, “the law governing mutual mistakes of fact” applies. See 98 Ariz. at 116, 402 P.2d at 546. They interpret this comment to mean that if EORP and the State could show that the parties to the Plan made a mistake about the Plan’s financial viability, the Bill’s retroactive changes would be permissible modifications of the Plan under Yeazell. But EORP and the dissent over-read Yeazell’s comment. Although this Court indeed said that the law of mistakes of fact applied to a pension plan if it was actuarially unsound, we expressly and carefully declined to address the consequences of such an application: “We do not, however, mean to imply what rights or remedies might be available to either party in a situation where it is established that a retirement plan is actuarially unsound. This is a matter beyond the issues of the present litigation.”
However, the Court quickly rejected the State's arguments in the following paragraphs:
This Court’s reticence was appropriate. While the defense of mutual mistake of fact applies in any contract dispute, EORP and the State are unable to prove that defense as a matter of law. That defense requires that the party seeking to void a contract prove that (1) the parties made a mistake about a basic assumption on which they made the contract, (2) the mistake had a material effect on the exchange of performances, and (3) the party seeking avoidance does not bear the risk of the mistake. Restatement (Second) of Contracts § 152(1) (1981); see also Renner v. Kehl, 150 Ariz. 94, 97, 722 P.2d 262, 265 (1986) (applying § 152 in resolving claim of mutual mistake of fact). EORP and the State cannot prove two of these elements.
First, EORP and the State cannot show that the parties made a mistake about a basic assumption of the Plan. They claim (and the dissent accepts, see infra ¶¶ 73, 104) that the mistake was the parties’ shared assumption that the Plan was actuarially sound, meaning that the parties mistakenly believed that the Plan’s investment returns would be sufficient to maintain the Plan’s actuarial soundness without changing the benefit increases formula or the employee contribution rate. But disappointment about anticipated investment returns does not qualify as a mistake. See Restatement (Second) of Contracts § 152 cmt. b (noting that “market conditions and the financial situation of the parties are ordinarily not such assumptions,” and “mistakes as to market conditions or financial ability do not justify avoidance under the rules governing mistake”).  Moreover, the Plan’s actuarial soundness is within the Legislature’s control. The Legislature is responsible for setting the amounts of the employer contributions and court filing fees, see A.R.S. § 38–810(B)–(D), and the Legislature may not “reduce the amount of the contributions to the fund if thereby the soundness of the fund is jeopardized,” Yeazell, 98 Ariz. at 116, 402 P.2d at 546. If the Plan is underfunded because of inadequate investment returns, the State may increase employer contributions and filing fees.
Second, even if unanticipated reductions in investment returns could qualify as a mistake, EORP and the State cannot show that the State did not bear the risk that this mistake might occur. The Legislature designed the Plan so that the State accepted the risk of variable investment returns. When investment returns are high, the State’s funding obligation through employer contributions is reduced or eliminated, as happened from 1998 to 2001. But when investment returns are low, the State’s funding obligation is necessarily increased. In either situation, however, the Class Members’ contribution rate remains fixed. Thus, the Class Members are not permitted to obtain any cost savings from higher investment returns, but they likewise are not required to pay more because of lower investment returns. The reward and risk of investment returns falls on the State. This is simply the nature of defined benefit plans. See Hughes Aircraft Co. v. Jacobson, 525 U.S. 432, 439 (1999) (stating that in a defined benefit plan “the employer typically bears the entire investment risk” and “must cover any underfunding as the result of a shortfall that may occur from the plan’s investments”). Because the State bears the risk of the claimed mistake, the State cannot rely on the defense of mutual mistake of fact to justify changes to the Plan.
Again, I have highlighted the numerous portions where the Court repeatedly argues that the poor financial performance of the pension's investments is not a justification for unilaterally changing, to the employees' detriment, the conditions of the pension contract in place at the time of hire.  I would argue that the sheer stupidity of the PBI formula, which was destined to lead to where we are now, was a mistake and enough to make its elimination or replacement constitutional.  This does not even take into consideration the immorality of the PBI formula as a form of inter-generational theft.

So, we can see that the Court did everything possible to lay the groundwork for a constitutional challenge to Proposition 124 by declaring the contribution rates at the time of hire a contract that cannot be changed simply because of the disappointing financial performance of the pension.  The Arizona Legislature did not subject EORP members to the same changes affecting PSPRS members.  This was probably due to the small size of EORP's membership, 1,591 total active and retired members as of the end of FY 2016, versus 30,569 active and retired members in PSPRS.  For some perspective, the Phoenix Police Department alone had 2,486 active members at the end of FY 2016.  I also suspect that the State and EOR did not want to tangle again with retired Judge Kenneth Fields, a committed fighter who would have surely challenged any changes to the PBI formula for EORP members.  Without EORP members being subject to Proposition 124, there was no reason for the Court to even consider the Contract Clause of the Arizona Constitution.  The Court found all it needed to make its decision in Yeazell and did not want to look any deeper or broader into the Arizona Constitution, and based on what they did put in the Hall decision, it seems to me that the Contract Clause would have only bolstered the decision in favor of the plaintiffs.

So what happens if Arizona voters approve an amendment to the State's Constitution that violates another part of the Constitution, as it seems like was done here?  I was hoping that there would be something in the Arizona Constitution that addressed this situation, but I found nothing in Article IV, Section 1 of the Arizona Constitution, which deals with the initiative/referendum process.  I did not read the entire Constitution, but my guess is that that is why we have an Arizona Supreme Court to decide difficult issues such as this.  Only they could decide which part of the state's Constitution has  has precedence over the other, and even their decision might not be final, as this could be an issue that goes all the way up to the United States Supreme Court.

I think that will eventually occur in some pension lawsuit somewhere in the United States.  As more and more states find themselves in the position of Illinois with pension burdens so onerous that they cannot pay for other necessary government functions, some state will, via the initiative or referendum process, attempt to greatly reduce the pension benefits of state employees and/or retirees.  I suppose Parker v. PSPRS could be as good a test case as any.  However, I have no insight into what Thomas Parker and his fellow plaintiffs and lawyers have in mind when they go before Judge Jo Lynn Gentry.  The excess contribution issue is already settled with only the final rate of interest to be decided, but could they ask Judge Gentry to consider the constitutionality of the replacement of the old PBI system with the new COLA?  What of L. Lee Rappleyea, the PSPRS retiree who sued PSPRS over the constitutionality of SB 1609?  Her case was never actually litigated because the decision in Fields was applied to her case.  Now she and her fellow plaintiffs are losers without ever having had their day in court.  Could she refile her case, claiming that Proposition 124 is violating her rights under the Contract Clause?  Or could someone else take up this fight?  I don't know.  Searching the Maricopa County Superior Court website, I find no new cases filed against PSPRS in 2016 or 2017, but I suppose a case could be filed in any court in the state.

If Proposition 124 were found to be unconstitutional, it would upset the whole apple cart of pension reform, and it would only take one PSPRS retiree or one active Tier 1 member to do this.  This would be a disaster for PSPRS, which if I had to predict, would lead to the final PSPRS reform: the complete elimination of any defined benefit pension plan for Arizona's future public safety personnel.  After all, this is what happened to EORP, which is now exclusively a defined contribution pension.  A successful repeal of Proposition 124 would show that any type of retroactive pension reform, with the possible exception of bankruptcy, is impossible.  It will just be simpler to go with a defined contribution plan that has predictable costs and benefits.

The next court date in Parker is for a status conference on July 12, 2017.  It will be interesting to see what happens and if a court date for oral arguments is eventually set for some time in the future.

Wednesday, June 28, 2017

PSPRS members: A preliminary estimate on how much pre-judgment interest you will receive on your excess contributions

Like many people, I am interested in how much pre-judgment interest will be paid.  This calculation is, unfortunately, not as simple as determining your principal owed, a figure now available on your PSPRS account.  However, I was able to calculate some rough estimates based on what we know now.

What I have heard is that pre-judgment interest will be simple interest, meaning that interest will not be earned on interest, only principal.  The formula I used was to take the expected interest rate, likely 5% per year, and divide it by the 26 biweekly excess contributions that were collected by PSPRS since the start of fiscal year (FY) 2012.  This biweekly interest (0.05/26) is 0.00192308.  So this is how much interest one would earn every two weeks on their accumulated excess contributions.  If we start with my very first excess contribution of $25 in July 2011, I would have earned $0.05 in interest two weeks later.  Assuming my next excess two weeks later remained $25, I would earn simple interest on $50, which would be about $0.10.  My cumulative interest after four weeks would then be $0.15.  On $75, I would earn $0.14 for a cumulative interest of $0.29 ($0.05 + $0.10 + $0.14).  Additional interest would be earned every two weeks all the way up until a final judgment on the excess contribution portion of Parker v. PSPRS, which may come July 12, 2017, the next court date in Parker.

My final refund total was right around $12,000, so every two weeks I will earn an additional $23.08.  This biweekly pre-judgment interest amount will not change as no more excess contributions are being taken by PSPRS.  However, it is possible that the rate could change to a post-judgment rate of 10% per year after the final judgment on the excess contribution portion of Parker.   The biweekly interest rate earned would double to over $46.  I suspect that there will not be any difference in the pre-judgment rate between Hall and Parker as the parties in Parker agreed to abide by the decision in Hall, but since they are two different cases, there still must be a formal decision in Parker by the judge in that case.  I also do not know if the plaintiffs in Parker are going to challenge the constitutionality of Proposition 124, which changed the permanent benefit increase (PBI) formula via voter referendum last year, as a violation of the contracts clause of the Arizona and US Constitutions.  Regardless, any unresolved constitutional issues will not affect the excess contributions issue.

So what was the final pre-judgment interest I figured for myself as of the end of June 2017 with the method I described?  I have an estimate of $1,420 total prejudgment interest at the 5% annual rate.  If I increase the interest rate to 5.25%, which would be 1% plus the prime rate in effect today (The Federal Reserve raised interest rates 0.25% on June 14, 2017, several days after the final decision in Hall.),  it will increase to about $1,489.  I would have preferred to create a table with different excess contributions amounts and estimated pre-judgment interest totals, but I feel that everyone's situation is probably so unique that it will give an inaccurate picture of their pre-judgment interest amount.   There are just too many different factors in how the excess contribution grew over time to make a generic table for everyone.  However, if you have been paying the excess contributions for the full time and are somewhere around $12,000 in total excess, $1,300 to $1,500 in pre-judgment interest is probably a good preliminary estimate at 5% per year.  Of course, this is just my methodology on pre-judgment interest.  It remains to be seen what PSPRS will actually do.