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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...

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.


  1. What about leaving the new COLA tied to the Consumer Price Index but changing the cap from 2% to 4%, which would be more inline to the original 4% cap.

    1. I think it would be possible to raise the cap as high as the legislature chooses. This would become a permanent change that could never be lowered. However, this increase would have to be paid for, though I am not sure how they account for the COLA. I don't know if it is part of normal costs or if employers are alone responsible for it. I would have to look closer at the legislation to see.

  2. The new cola is accounted for in the normal costs. As you know for tier 1 and 2 the employee rate is fixed... Also if anyone thinks the Republican controlled leg is going to increase that cap anytime in the foreseeable future I got some ocean front property in Arizona for you.

    As far as the board, the new board has only been in office for 7 months. So criticizing the makeup is pre mature. If u attend or listen to the meetings the taxpayers members and the employee members seem to be on the same page trying to fix the system.


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