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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...

Friday, August 31, 2012

Labor Day reality check for PSPRS members

The Arizona Republic has done the best reporting on Arizona's distressed public pensions.  This June 23, 2012 article by Craig Harris (Pension funds in Arizona facing bleak future) is such an example.  It gives an honest view of the scope and intractability of the problem.

CalPERS, California's massive public employee pension system, earned a miniscule 1% on its investment portfolio for the fiscal year ended June 30, 2012.   Mr. Harris' article indicates that PSPRS will likely show disappointing returns also.  While PSPRS' consolidated annual financial report (CAFR) will not be released until later this year,  PSPRS Administrator Jim Hacking says that for PSPRS, "The picture is not good," and that he believes its funding ratio will drop below 60%.

If you have Labor Day weekend plans, wait until Tuesday to read the article.

Wednesday, August 29, 2012

DROPping the ball

 "We have met the enemy, and he is us."
                                           Walt Kelly's comic strip character Pogo

HB2409 was signed into law by Governor Jan Brewer on May 14, 2012.  While this bill modified other PSPRS provisions, the most important change involved the Deferred Retirement Option Plan (DROP).

SB1609, passed in 2011, made major changes to the DROP.  It eliminated the DROP for anyone hired January 1, 2012 or later.  Those with 20 years of service before that date would be still be able to DROP under the provisions in place before SB1609 went into effect.  Those hired before January 1, 2012 but without 20 years of service at that date would see a change in how interest is calculated and be required to pay into PSPRS during their time in the DROP.

HB2409 now requires contributions made during a member's time in the DROP to be refunded to the member when the member leaves the DROP.  It also requires that a 2% interest rate be paid on those contributions as long as PSPRS earned at least 2% in the prior fiscal year.

The DROP was a short-sighted and irresponsible program from the very beginning, and it worsened the financial condition of PSPRS.   SB1609 attempted to remedy some of the problems with the DROP, first by killing it off for future hires, but also by requiring some sacrifice by current members.  It should have jettisoned the DROP completely or, at least, required ALL DROP participants who entered after January 1, 2012, regardless of their years of service, to continue making member contributions.  Instead, it only affected those with less than 20 years of service as of January 1, 2012.  While not ideal, this reform was better than nothing.

Now we see even this minimal reform rolled back.  This myopic legislative "victory" is an insult to those yet to be hired, and it represents part of the erosive process that will reverse the necessary changes PSPRS needs to survive. 

The agency problem and public employee pensions

Jack Cross, the administrator of PSPRS from 1983 to 2004, has been accused by current PSPRS officials of improperly increasing his own pension (ABC15 Investigates: Former police and fire pension fund manager accused of inflating his own pension).  After an internal audit, Mr. Cross' monthly pension benefit was suspended by officials to recoup an alleged $600,000 in overpayments.  Mr. Cross, who draws his pension through the Elected Officials' Retirement Plan, filed a lawsuit in March 2011 to overturn this suspension and alleges that his benefit should have actually been higher.  Maricopa County Superior Court records show this case is still ongoing.  This shows a classic example of the agency problem.

The agency problem or principal-agent problem describes an inherent dilemma in organizations.  In business the dilemma is between the principal, the owner or stockholders, and the agents, the managers.  While both parties have general common interests such as keeping the business solvent, each party wants to maximize his gain from participation in the relationship.  The agent has multiple interests that includes pay and benefits, power, career advancement, and self-esteem.  The principal is primarily interested in maximizing the return on his investment.  Stock options, employee stock ownership, and profit-sharing are all ways businesses try to align the interests of principals and agents to minimize the agency problem.

While Mr. Cross' alleged transgression makes a perfect business school case study of the agency problem, its impact on PSPRS' finances is small.  The real agency problem  for PSPRS and pensions like it involves public employee unions and politicians.  Representatives of public employee unions act as agents for their members, both current and future.  Politicians are agents for both employees, retirees, and taxpayers.   All the principals have an interest in the pension remaining viable for the indefinite future.

However, the self-interest of union representatives and politicians can vary with their principals.  Union representatives, who are generally the most senior employees and closest to retirement, will necessarily have an interest in maximizing their own retirement benefits to the detriment of more junior members as well as future hires.  Politicians have self-interest in keeping their jobs and will have an incentive to help special interest groups, like public employee unions, who help them stay in office.  Taxpayers, who have a huge, long-term financial stake in PSPRS' operation but are unaware of its problems, have their interests ignored by short-sighted politicians who care only about winning the next election.

This also helps answer the question posed in the prior post about why Stockton used bonds to finance enhanced pension benefits.

Monday, August 27, 2012

Moral hazard and public employee pensions

Though the term seems to have popped up just in the last few years, moral hazard has long been a financial and ethical concern in the insurance industry.  The "hazard" in moral hazard is that once property is insured, the owner of the insured property has more incentive to risk that property since the financial consequence of property losses are borne by someone else.  This is why there are deductibles, co-pays, and co-insurance in insurance policies.  By forcing the insured to have some skin in the game, the insurer can mitigate moral hazard, charge reasonable rates, and make a profit.

However, the current use of the term moral hazard and its counterpart "too big too fail" usually refer to financial markets.  In a similar vein as insurance moral hazard, large financial firms are more likely to take risks because the government will be there to rescue them if they get in trouble.  Because the demise of one large financial firm can affect the entire world economy, those managing those firms may feel that they are, in essence, "insured" by the government.  Of course, the government (i.e taxpayers) never agreed to be this insurer of last resort and is paid neither profits from risky ventures nor any underwriting fees.

This brings us to the moral hazard of PSPRS and other public employee pensions.  Though PSPRS is a multi-billion dollar fund, its demise would pose no risk to the world economy.  The moral hazard in PSPRS comes from legal protections based on both contract law and the Arizona Constitution.  Since benefits can never be altered once they are awarded, the incentive will always be for current employees to obtain as many benefits as possible at every opportunity available and never concern themselves with the ultimate risk to PSPRS.  When those benefits become financially unsustainable, the taxpayers, primarily, and future hires, secondarily, will be stuck paying the tab as the final "insurers."  The members receiving enhanced benefits, the politicians who approved the benefits, and the unions who lobbied for them suffer none of the consequences of this folly.

The question posed in the last post about why Stockton borrowed to fund enhanced pension benefits is partially answered here.  And to bring things full circle since this started with a discussion about insurance, read the following New York Times article by Mary Williams Walsh (Creditors of Stockton Fight Pension Funding While in Bankruptcy) to see how moral hazard is being dealt with by actual insurance companies.

Eat, drink, and be merry for tomorrow our pension may die.

California's bankrupt cities are an easy target for ridicule, and the intention here is not to kick them while they are down.  However, this column about the city of Stockton (The State Worker: Are public pensions at risk in bankruptcy?) includes a small bit information that warrants comment.

Jon Ortiz writes that Stockton, "borrowed $125 million from the bond market 5 years ago to pay for a pension benefits hike."  This is wrong on so many levels that it is difficult to understand how anyone could even propose something so irresponsible, much less actually implement it.

Bonds are supposed to be an investment.  While governments do not invest in the sense that individuals or businesses do because they have no expectation of direct profit, there is an expectation of gain through other means.  Better roads, schools, water treatment facilities, etc. are funded with bonds because in the long run the community profits through the betterment of citizen's health and comfort and a more attractive business environment.

Using bonds to fund a benefit increase is borrowing to pay operating expenses.  If this were a business, this would be a red flag that the business was having serious problems and may not be a going concern.  Of course, a government has a captive customer base and can always bring in more revenue via taxes, but this still leaves open the question of why Stockton would do something so self-destructive to itself and its citizens.

The next posts will attempt to address this question.

Friday, August 24, 2012

Have a COLA and a smile

Though Arizona SB1609 was signed into law on April 29, 2011, there has already been a successful court challenge to a key provision of the law. The successful challenge (Maricopa judge: Halting pension raises unconstitutional) by retired Arizona judges affects the Elected Officials' Retirement Plan (EORP).  EORP is a pension plan pension similar to PSPRS, but its membership is significantly smaller.  The judges argued that any change to their cost of living allowances (COLA) violated the Arizona Constitution, which states that "public retirement benefits shall not be diminished or impaired."

Before SB1609, COLA's in both PSPRS and EORP were paid out of a reserve funded by excess returns earned each year.  Any year that PSRPS or EORP earned more than 9%, a portion of that excess amount was placed in a Reserve for Future Benefit Increases.  As long as funds were available in the Reserve for Future Benefit Increases, a permanent COLA of up to 4% of the average benefit being paid at the end of the prior fiscal year was awarded to retirees.

The problem with this system of awarding COLA's is that it only took into consideration the past year's performance and not the overall health of the pension. A period of negative or substandard returns could cause the funded ratio of  PSPRS and EORP to plummet, but when the rate of return again exceeded 9% money would flow into the Reserve for Future Benefit Increases.  Instead of all excess returns being used to return the pension to a healthy funded ratio, a portion of the excess was being set aside for COLA's.  Retirees were rewarded during good years but shared none of the pain of the bad years.  The burden of bringing the pension back to full health was left on the backs of taxpayers and current employees.

SB1609 changed this arrangement by tying COLA's to both annual returns and the funded ratio of the plans as follows:
  • If the ratio of the actuarial value of assets to liabilities is 60-64% and the total return is more than 10.5% for the prior fiscal year, 2% maximum increase to all eligible retirees and survivors.
  • If the ratio of the actuarial value of assets to liabilities is 65-69% and the total return is more than 10.5% for the prior fiscal year, 2.5% maximum increase to all eligible retirees and survivors.
  • If the ratio of the actuarial value of assets to liabilities is 70-74% and the total return is more than 10.5% for the prior fiscal year, 3% maximum increase to all eligible retirees and survivors.
  • If the ratio of the actuarial value of assets to liabilities is 75-79% and the total return is more than 10.5% for the prior fiscal year, 3.5% maximum increase to all eligible retirees and survivors.
  •  If the ratio of the actuarial value of assets to liabilities is 80% or more and the total return is more than 10.5% for the prior fiscal year, 4% maximum increase to all eligible retirees and survivors.
This new arrangement is still generous but obviously fairer.  It not only raises the rate of return threshold from 9% to 10.5% but links the maximum allowable COLA to the funded ratio.  The retired judges did not agree that this new arrangement was fair, and their position that this was a violation of a contractual agreement and unconstitutional was upheld.  This successful challenge will certainly encourage those who already have active court cases about PSPRS COLA's as well as those considering filing them.  It will also embolden those who are thinking of challenging other provisions of SB1609.

Forgotten in all this is the pension itself.  The task of returning it to fiscal health is only going to get that much harder as these lawsuits chip away at the minimal reforms that SB1609 has already enacted.

Wednesday, August 22, 2012

PSPRS pension returns vs. S&P 500

The following is  from the Arizona Auditor General procedural review of the Public Safety Personnel, Corrections Officer, and Elected Officials' Retirement System dated November 16, 2011:
From fiscal years 1991 through 2010, the System's total investement performance averaged just over 7 percent annual gains.  This performance was nearly 2 percent lower than the actuarially assumed return of almost 9 percent.  It was also nearly 1 percent lower than the rate of return achieved by the Arizona State Retirement System (ASRS), the state agency that manages the retirement benefits for the State of Arizona, school districts and charter schools, some cities and towns, all 15 Arizona counties, and numerous special districts.  During the same period, the ASRS slightly exceeded its own actuarially assumed rate of return of 8 percent.
The System's actual rate of return exceeded the actuarially assumed rate of return in some years but dropped below it in others.  The overall result is a cumulative rate of return of about 300 percent for fiscal years 1991 through 2010.  This means that each dollar in the fund in fiscal year 1991 earned $3.00 by fiscal year 2010 through the System's investment strategies.  To match the actuarially assumed rate of return during the period, however, each dollar in the fund in fiscal year 1991 should have earned about $4.50.  The System's underperformance resulted primarily from losses experienced in fiscal years 2001 through 2002 and 2008 through 2009. 
To put this in perspective, at the end of June 1990, the S&P 500 index was 358.02.  At the end of June 2010, it was 1,030.71 in June 2010.  This produces an average annual return of 5.7% over the 20 year period.  This reflects only the actual change in value of the S&P 500 and does not include any dividends paid (I could not find historical data on dividend yields) or savings in fees and commissions.  The S&P 500 closed today at 1,413.49, and the S&P 500 depository receipt (SPDR) currently yields 1.98%.

So a large, professionally managed system with access to multiple investment vehicles and advisors returned only a little more than a passive index fund and may have actually returned less when dividends are figured in.  While the report explains that overconcentration in stocks, particularly in certain sectors, caused some of the biggest losses, this shows that individual investors are not the only ones who find it difficult to beat the market.  This is also why many financial planners believe passive investing in broad exchanges is the only way individual investors can realize gains on their portfolios.  A study by two Maryland think tanks (States Pensions Get High Fees, Low Profits -- Study) concurs with this belief in regards to pension funds as well.  Their study finds that underperformance of money managers combines with their high fees to cost pensions billions.

PSPRS has altered its investment portfolio significantly over the last few years, moving more of its largest stock holdings out of individual stocks and into mutual and exchange traded funds and lowering its percentage invested in stocks from 67.79% at the end of FY 2008 to 35.90% at the end of FY 2011.  However, PSPRS has also diversified into hedge funds and private equity firms, the types that the Maryland study criticizes.  Time will tell if these investments will pay a percentage high enough over passive investments to justify the increased fees.

Thursday, August 16, 2012

If you read only one article about public sector pensions, read this one.

Girard Miller has an excellent piece from January 2012 in Governing magazine  (Pension Puffery: Here are 12 half-truths that need to be debunked in 2012) that gives a very honest and straightforward information about public sector pensions. 

The most telling passage of the piece is included under Half-truth #4: "Experts consider 80 percent to be a healthy funding level for a public pension fund.  Mr. Miller writes:

Until the last recession, respectable and world-wise actuaries would tell you privately that when a pension system gets its funding ratio above 100 percent, there is a political problem. Employees, unions and politicians suddenly become grave-robbers who invariably break into the tomb to steal enhanced benefits and pension contribution holidays. So these savvy advisors historically have tolerated modest underfunding, based on their recurring past experience with the forces of evil in this business. They figured the ideal public plan would drift between 80 to 100 percent funding over a market cycle, and nobody would be hurt if the plans were a "little bit underfunded" in normal times.

So actuaries not only have to manage pensions, they have to defend them against those who would snatch away any surplus.  Mr. Miller kindly refers to this as a political problem, but it is actually a greed problem.  This goes a long way to explaining how we got to where we are now.

It never made any sense that PSPRS implemented the DROP just as the dot-com bubble was bursting, but this was also at a time when PSPRS was running a surplus.  The surplus that might have been used to offset impending losses was instead used to enhance benefits.  This may be speculation, but it certainly seems to fit the scenario Mr. Miller describes.

Read the whole article.

Dollars and cents

To better illustrate the point of the previous post, the following table shows the growth in the annual required contribution that the city of Tucson must pay to PSPRS for the Tucson Police and Fire Departments:

Fiscal Year Annual Required Contribution 
Ended June 30 Tucson Fire  Tucson Police 
2003 $1,724,572  $2,991,820
2004 $2,653,025  $5,139,889
2005 $4,621,390  $7,141,031
2006 $5,100,332  $9,875,566
2007 $7,260,919  $11,594,623
2008 $9,981,531  $15,011,174
2009 $12,625,922  $19,047,609
2010 $10,905,280  $17,040,897
2011 $11,200,199*  $18,245,945*
2012 $12,271,596*  $19,318,226*
(Source: June 30, 2010 annual actuarial valuation of members reports for Tucson firefighters and police covered by the Arizona PSPRS by Gilbert Roeder Smith & Company)

This shows more clearly with actual dollar amounts, rather than percentages, the costs incurred by the taxpayers of Tucson to fund PSPRS.  This has occured as attrition has shrunk the ranks of Tucson Police and Tucson Fire over the past several years.

While active members are also paying more than they were a few years ago, it is easy to see where the bulk of the financial burden falls when PSPRS is underfunded.

Wednesday, August 15, 2012

Why is everybody picking on us?

As one way to explain some of the escalating hostility to public employee pensions, see the following table, which shows the historical employer contribution rates to PSPRS:

Fiscal YearEmployer RateFiscal YearEmployer Rate

* Projected rates in fiscal year (FY) 10-11 annual report

The employer rate is the annual contribution as a percentage of member payroll that employers must make to PSPRS. The employee rate had been fixed for many years at 7.65%, but began to rise in FY 11-12 and will eventually top out at 11.65% in FY 15-16.  The employee contribution rate is currently 9.55%.

As can be seen from the table, the employer contribution rate has varied wildly since PSPRS was created.  The rate differs from year to year based on the funding ratio of PSPRS.  The funding ratio as of June 30, 2011 was 61.9%.  (A 100% funding ratio would mean that the pension is able to meet all its obligations now and into the future.)  When the funding ratio is low the employer contribution rate can be exected to go up, and it will decrease when PSPRS is fully funded.  However, the rate never dropped to zero, even when PSPRS' funding ratio was over 100%, as it was for a brief time during the early part of the last decade.

What angers and motivates critics of public employee pensions is the open-ended commitment taxpayers have to fund plans like PSPRS.  No matter how underfunded PSPRS gets, employees pay a fixed amount, but taxpayers have a virutally unlimited liability.  If rates of return are lower than expected or investment losses are incurred or payrolls decline, taxpayers will have to pay more and/or see government services decrease. 

The Board of Trustees Transmittal Letter from the PSPRS FY 10-11 Annual Report states, "With further erosion of the Plan's funding status expected to occur over the next several years, the forecast is that the employer contribution rates will continue to increase unless the Plan experiences far better than expected investment returns."  So do not expect the hostility to subside anytime soon.

Tuesday, August 14, 2012

What if?

The sorry state of city of San Bernardino's finances become clear when one reads the following: Pension costs lead to San Bernardino's debts.

San Bernardino owes the California Public Employee Retirement System (CalPERS) over $143 million.  Furthermore, it owes almost $50 million more in other pension liabilities.  This is in a city that has a $166 million 2012/13 budget, which the city manager says needs to be cut by $46 million in order for San Bernardino to remain solvent.

San Bernardino filed for Chapter 9 (municipal) bankruptcy on August 2, 2012.  This will allow it to renegotiate debt and/or interest rates with creditors at the discretion of the court.  However, both the city attorney and employee representatives predict that the outstanding pension obligations will be paid.  The question is by whom.

The citizens of San Bernardino have already seen decreasing city services with a another massive cut coming in the near future.  More frightening is the idea that the city could essentially shut down with not a single service provided, and it would still be over a year and a half before their pension obligations were paid off.  Taxpayers have the dubious distinction of being the only asset, in the form of their future tax payments, that San Bernardino has.  However, this asset can vote at both the ballot box and with their feet, and it may decide that the sins of politics past is not their burden to bear.

Where does this leave the retirees and current city employees?  The sanguine comments by the city attorney and employee representatives is supported by the conventional thinking about the sanctity of public pension obligations: they are a contractual obligation that must and will be paid.  However, all San Bernardino's creditors will have to stand before the bankruptcy judge and make their case.  CalPERS most likely will push itself to the head of the line and retirees and current employees will get what they were promised.  But what if that doesn't happen, if not in San Bernardino's case, another bankrupt city's?  A judge may acknowledge that a bankrupt city is in a death spiral that can not be halted unless all contractual obligations are on the table and everyone is forced to take less.

People will continue to adamantly deny that this will ever happen, but are you willing to bet your retirement on it?

Thursday, August 9, 2012

You don't have to like it, you just have to pay it!

It is common knowledge that Social Security will eventually be unsustainable, and there will not be enough active workers to pay the taxes for those already drawing benefits.  However, there's nothing like rubbing this fact into the noses of those still working (Social Security not deal it once was for workers).

The idea that a retirement program should ever be a better "deal" for one group versus another is counter to all that  a retirement program is meant to do.  Fundamental to all retirement plans are the expectations that pooling of investments will maximize returns over the time, that an actual return on your investment (at a minimum over the rate of inflation) is delivered, and that there is a managed system in order to maintain sufficient funds to pay all participants in the plan.  If one group gains more at the expense of another group, this is simply a form of expropriation.  In the case of Social Security, it is a case of inter-generational theft.

Social Security has numerous problems, most significantly is that benefits are paid to current retirees from the taxes of current workers.  Social Security ran a surplus for many years in order to build up a reserve for future obligations, but this surplus was "invested" in US government securities.  This is the equivalent of one spouse lending the family retirement savings to the other spouse to pay all the monthly bills.  There is an obligation there, but in the end they will still have no money left in their retirement account.

PSPRS, fortunately, does not operate that way. PSPRS owns an actual pool of investments with measurable value.  These investments have an expected rate of return that should produce enough investment gains to pay everyone who participates.  However, there is some of the same unfairness going on in PSPRS as in Social Security.  PSPRS essentially has a three tier Deferred Retirement Option Plan (DROP):

  1. For those already in the DROP before 1/1/2012: they get a guaranteed interest rate (currently 7.85%) on their DROP money and do not pay any contributions to PSPRS.
  2. For those already hired before 1/1/2012 but without 20 years service: they get a minmum rate of 2% or the 5-year average actual rate of return of the system (currently 3.8%), whichever is higher.  They must continue to pay into the pension during their time in the DROP but will have these contributions returned with interest to them after they leave the DROP.
  3. For those hired on 1/1/2012 and later: No DROP at all. 
The final monetary payout between the first two tiers is probably small, but the third tier is definitely being given a raw deal.  To add insult to injury, they will be paying a higher contribution rate (currently 9.55% and topping out at 11.55% in two years) to PSPRS for probably their entire careers.  So not only are they being denied a significant benefit, they get to pay more out of every paycheck to make sure all those before them get it.

While it would be an exaggeration to call this expropriation since tier three members should still be get back much more than they pay into the system, this situration is very unfair and needs to be acknowledged as such.

What this blog is/does and is/does not*

This blog is/does:

  1. Dedicated to discussion and information about the Arizona Public Safety Personnel Retirement System (PSPRS).
  2. Believe that a defined benefit pension can work, if managed in a financial realistic manner.
  3. Concerned that short-term thinking about maximizing returns of those closest to retirement will eventually cause permanent damage to PSPRS.
  4. Concerned about the long-term viability of PSPRS and the fair treatment of both members and taxpayers.
  5. Concerned that future members (those hired after 12/31/2011) will be left a weakened and substandard retirement system. 
  6. Welcome any individuals who have expertise in pension accounting, actuarial science, or pension law or policy.
This blog is/does not:

  1. Anti-public safety personnel.
  2. Anti-union.
  3. Advocate a switch to a defined contribution system.
  4. Point fingers at any individual, as any individual should do what is best financially for him or herself.
  5. A forum for general political discussion.
*This list is open to additions and deletions, as necessary.

Are PSPRS members living in an alternate reality?

The New York Times featured an editorial (Our Ridiculous Approach to Retirement) on July 21, 2012 by retirement policy specialist Teresa Ghilarducci that details how difficult it is for all but the most dedicated savers to amass an adequate nest egg, in addition to Social Security, that will support them in retirement.

Ms. Ghilarducci writes that human nature conspires against us to limit our savings, particularly in our early working years.   Denial and unreal expectations cause many to live in a alternate reality that will disappear once they actually retire.  She mentions her own plan that would require a radical rethinking of current personal retirement accounts like 401k's, 403b's, and 457b's.    So what does this have to do with Arizona state Public Safety Personnel Retirement System (PSPRS)?  Several things:

1. PSPRS is not a supplement to Social Security like most employees' retirement accounts.  For firefighting and law enforcement personnel PSPRS is their Social Security.  The ironclad protection that most assume for Social Security is assumed for PSPRS as well, but how secure is PSPRS, or any other defined benefit pension, for that matter?  Is it realistic to rely solely on a PSPRS pension for your retirement income?

2. Pension accounting and actuarial science is extremely complicated and the realm of a specialized experts, and if it is difficult for individuals to manage a personal retirement account, how can the average PSPRS member understand how the pension is being managed?

3. Finally, we get to the most delicate question for PSPRS member.  Are the ones who lobby our state legislators about pension legislation really looking out for what is best for the long-term financial health of PSPRS (and its ability to pay both current and future retirees)?  Or are they maximizing current benefits and passing a huge financial burden on to PSPRS member not yet hired, as well as taxpayers?

Honest information and discussion is the only way to answer these questions, and if PSPRS members do not look out for themselves via vigilance and education, who will?