Featured Post

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, December 30, 2012

The 2013 PSPRS plan: More Taxes

The following paragraph from PSPRS' 2012 Consolidated Annual Financial Report (CAFR) is included in the introductory letter by the Board of Trustees:
In the short term, and while awaiting final court decisions in the lawsuits challenging the changes made by the pension reform bill to the Plan's COLA and to member contribution rates, the Board of Trustees has directed the System's staff to urge the PSPRS constituent organizations and the employer groups to come forward with legislative proposals to add additional sources of revenue to supplement the revenue derived from contributions and investment return.  This seems to be the only means available in the short term to improve the Plan's funding status and diminish the upward trend of employer contribution rates.
In both its content and its presentation this passage verges on satire.  Filled with bureaucratic euphemisms, it attempts to disguise the Board's impotence and lack of ideas with a call to "constituent organizations and the employers groups to come forward with legislative proposals to add additional sources of revenue to supplement the revenue derived from contributions and investment return."

Translated into plain English, this means that the Board has no idea how to get PSPRS out of its financial crisis so they want retirees, employees (i.e. public safety unions), and local governments to pressure lawmakers to find new and creative ways to extract more tax money from Arizonans because PSPRS can not fund itself the way a defined benefit pension is supposed to.  This all comes from the group that is tasked with ensuring PSPRS is managed properly (Trustees were called Fund Managers up until 2009).

Of course, the problems with PSPRS are not fault of the current Trustees. All the current Trustees joined the Board after June 30, 2008, when most of the damage to PSPRS was already baked into the cake, and they are now presiding over a mess that was years in the making. However, this underwhelming statement of action can do nothing but disappoint PSPRS members and infuriate Arizona taxpayers.

Where the Board expects any "additional sources of revenue" will come from is a mystery.  Arizona taxpayers already pay a hidden tax in the form of fire insurance premium taxes that brought $12.2 million into PSPRS in FY 2012.  In November Arizonans  passed an initiative that limited property tax increases and refused to make permanent a one cent sales tax increase, so it is unlikely that there is a welcoming environment for anymore taxes, especially for a pension system that continues to lose money on its investments and takes more each year from employers and employees.  Furthermore, PSPRS' financial plight is unlikely to get much sympathy when taxpayers see PSPRS members so selfish that they are willing to drive PSPRS further into deficit so that they can continue to get annual raises.

2013 is not starting off very well for PSPRS.

Friday, December 21, 2012

PSPRS Members: Spend a few minutes reading PSPRS' 2012 Financial Report

The Arizona Public Safety Personnel Retirement System (PSPRS) Consolidated Annual Financial Report (CAFR) for the fiscal year ended June 30, 2012 is now available online.  Readers who are interested can find the report at the referenced link.  There will be more commentary on the report in future posts, but if you read only part of it, read the introductory letters by both the board of trustees and the system administrator starting on page nine of the CAFR.  They give a good idea of the legal and financial challenges facing PSPRS.

Friday, December 14, 2012

Working hard and retiring smart

I always cringe when articles like this one by Bloomberg, $822,000 Worker Shows California Leads U.S. Pay Giveaway, appear.  They decry the large overtime and sick leave payments and, invariably, highlight a few unfortunate individuals for exposure.  For better or worse, the salaries of public employees in Arizona are public record, and there are several searchable online databases that contain this information.

I can not speak to all government employees, but there is some additional explanation necessary for overtime and sick leave when it comes to public safety.  Due to the nature of their work, public safety departments try to  maintain constant staffing, which means they make every attempt to fill positions vacant due to sickness, injury, or vacation, so that the minimal level of service can be provide 365 days of the year.  This avoids brownouts or other service gaps that compromise public safety.  In order to do this, overtime becomes unavoidable and sick leave use is discouraged in order to keep those very same overtime costs down.

While there are no doubt plenty of abusers of overtime and sick leave policies, many of these costs are unavoidable.  If employees were not compensated for unused sick leave (usually at 50% of final hourly wage), they would simply use it.  We can debate the ethics of using sick leave when one is not sick, but the economically smart decision would be to use a benefit rather than lose it.  As for overtime, there are some employees that are more willing to work it.  Whether it is for financial reasons or sheer love of the work, some people are going to work more overtime while others may work none.  It is just another aspect of human nature that must be acknowledged and dealt with.

The real problem with overtime and sick leave sellback is how they are used to calculate pensions.  Since pensions, like PSPRS, are calculated on either an individual's high three-year or high five-year salary, the wise financial decision is to work overtime and sell back sick leave during those high salary periods.  This practice, often referred to as "pension spiking," creates an artificially higher pension that does not reflect what the individual paid into the pension over his total years of employment.  Pensions are supposed to use long-term compounding to achieve returns to pay future benefits, but pension spiking negates this advantage.

Employees should have overtime and sick leave sold back recognized in their pension, but there should be a formula where overtime worked and sick sold back over the employee's entire career is used to calculate a final pension, not just the a high years' period.  This would make more actuarial sense and protect the long-term health of the pension.

As a final note, the attempt to demonize individual employee's is not fair as one should always do what is best for oneself and one's family.  If an employee fairly utilized the rules in place to maximize his pension, the employee is not a villain.  The problem with the article referenced in the first paragraph is that egregious individual cases are the main takeaway.  This is a systemic problem, not a problem with individual greed.

Thursday, December 13, 2012

San Bernardino vs. CalPERS: Bust-out or betrayal

The ongoing battle between the city of San Bernardino and the California Public Employees Retirement System (CalPERS) was briefly dealt with in the post "What if?," but for a more detailed explanation of what happened in San Bernardino, readers should check out this article, (From suburb to basket case: How California city traveled the road to ruin).

San Bernardino may be the current poster child for out-of-control pensions, but it may go down in history for a more important reason.  It may become the city that changes how pension debts are treated in bankruptcy (CalPERS triggers legal fight with bankrupt San Bernardino over pension debt).  If San Bernardino can have its debt to CalPERS treated similarly to other liabilities, this would become a precedent that would alter the landscape for all public pensions.  If bankrupt government entities are only required to repay some portion of their pension debt, public pensions will be left with no way to recoup those lost funds to pay current and future retirees.  Even more important is the moral hazard that other cities, counties, etc. will feel less compelled to manage their finances as judiciously if they can vacate debts to their largest and historically untouchable creditor in bankruptcy court.  If San Bernardino succeeds, who else might consider a bankruptcy to get out from under their pension debt?

On the flipside, what other choice does San Bernardino have?  They can not pay their debt to CalPERS and remain a functioning city.  The debt is so large that it seems unlikely that San Bernardino could ever repay it, and attempting to do so would turn the city into just a transfer agent of taxes to CalPERS.  CalPERS seems to have the same bureaucratic indifference towards San Bernardino's plight that a large bank does toward a down-on-his-luck homeowner in foreclosure.  If CalPERS has to bust out San Bernardino to get its money, so be it.

Most everyone can guess how this will end because the little guy usually gets it in the end.  It just depends on which little guy gets the worst of it: the taxpayer or the employees and retirees.  If CalPERS wins, San Bernardino will continue its slow death as services are cut and residents and businesses relocate as the city spends its dwindling tax revenue on debt service.  If San Bernadino wins, it becomes more interesting.  If San Bernardino has its debt reduced, does CalPERS make up the shortfall so that San Bernardino's pensions will still be paid as promised to both retirees and current workers?  Or will retirees and current workers see their pensions reduced in a manner that corresponds to the shortfall?   I would bet on the latter since CalPERS has no realistic option to obtain additional funds, and CalPERS would soon find itself insolvent as well if it had to make up every shortfall caused by a bankruptcy.  Needless to say, the taxpayer is going to suffer under either scenario, but less so under the second one.

There is no good solution to the situation in San Bernardino, and even bankruptcy experts are not sure how it will end.  The one sure thing is that some people are going to get shafted.

Tuesday, December 11, 2012

PSPRS Members: Will a COLA be paid next year?

PSPRS' most recent actuarial report for the fiscal year ending June 30, 2012 shows that PSPRS has a funding ratio of 58.6% and had a -0.8% return for the year.  These numbers are important for retirees because they are used to determine whether PSPRS will pay a cost of living allowance (COLA) during the next fiscal year.  PSPRS must have a minimum funding ratio of 60% and earn at least a 10.5% return for the previous fiscal year in order for a COLA to be paid.  Neither of these conditions were met, but PSPRS retirees received a COLA for the current fiscal year because funds remained in the Reserve for Future Benefit Increases that existed under the old COLA system.

However, this should be the last COLA awarded under the old system as the Reserve for Future Benefit Increases will soon be exhausted.  The elimination of this old system, which virtually ensured COLA's would be paid every year, was a key part of the pension reform included in SB 1069.  With PSPRS' funding ratio below 60% and likely to continue dropping, the prospects of COLA's in the next few fiscal years are very dim.

Yet there is still a good chance that the old COLA system may return.  The previous post, (Have a COLA and a smile), detailed how some retirees in the Elected Officials' Retirement Plan (EORP) were able to successfully challenge a similar change to their COLA system.  This case is currently under appeal, and other cases, by both active and retired EORP and PSPRS members, are also challenging the changes to COLA's as a breach of a binding contract and a violation of the Arizona Constitution.

This may sound like good news, but if any or all of these cases are successful, they will eliminate one of the key reforms to PSPRS, slow PSPRS' return to financial health, and continue to reward retirees at the expense of current employees and taxpayers.

PSPRS members: Assumed rates of return can make an ass out of you and me

While the Khan Academy is a good starting point for understanding the public pension crisis, those desiring a more detailed explanation should read Andrew Biggs' paper Public Sector Pensions: How Well Funded Are They, Really?

Mr. Biggs' paper concerns how public pensions set their assumed rates of return (ARR).  Also called the expected rate of return, the ARR is probably the most important factor in determining the funding status of a pension.  The ARR is the rate a pension expects to earn on its investment portfolio, so the ARR determines the contribution amounts made by employees and employers.  The higher the ARR the more the pension can expect to earn through its investments.  A higher ARR also means lower contribution rates for employees and employers.  The danger is that if the ARR is too high, the earnings of the pension going forward will be insufficient to meet its future financial obligations..

Mr. Biggs' critical point is that public pensions have erroneously based their ARR's, currently averaging around 8%, on historic market returns.  While this may seem like a sound strategy for long-term investing, it ignores the tradeoff between risk and return.  Mr. Biggs writes that pension obligations are guaranteed obligations, and the expectation that they will be paid is virtually certain.  This means that a pension should invest in as risk-free a portfolio as possible.  This would mean investing in U.S. Treasury securities, or minimally, in high-grade corporate bonds at rates in the 3-5% range.  In order to get an 8% return, a pension has to make riskier investments.  If those higher-risk investments lose money, the pension will not be able to meet its future obligations.  This is where many public pensions are today.

PSPRS maintained an ARR of 9% for 20 years between 1984 and 2004, but the ARR has been incrementally lowered since 2004 and will be at 7.85% for the next fiscal year.  For PSPRS the past dozen years have shown the dangers of having an overly optimistic ARR, along with two market crashes.  I can remember being told, back in 2000 when I came on the job, about the investing genius of PSPRS' then-administrator.  It was true that Jack Cross, the administrator from 1986 to 2004, had produced impressive gains for most of that time, but the end of his tenure was marred by large losses caused by the dot.com bubble bursting.  After Mr. Cross' retirement PSPRS took actions to diversify its holdings more widely and not concentrate so heavily in stocks.

While some have attempted to point the finger at Mr. Cross for PSPRS'current underfunding (Risky investments, poor oversight lead to $1.6B taxpayer bailout of police and fire pension fund), he seems to be just a convenient scapegoat for what appears to be standard practice among the vast majority of public pensions.  Though he was never the investment master that he was made out to be, he was not doing anything out of the ordinary for either public pensions or other knowlegeable investors, both amateur and professional.  This also conveniently ignores the fact that Mr. Cross was long gone when the housing bubble burst, after diversification was supposed to limit the impact of another market crash.  The simple truth is that anyone can be a genius in a bull market, and anyone can be made a fool during a market crash.

This gets us back to Mr. Biggs' central argument.  Government employers and employees like high ARR's because they mean lower contribution rates, and everything had worked fine until reality intruded.  Public pensions simply can not invest like other investment pools because the cost of losses greatly outweighs the potential gains of more risky investments.  If a public pension lowers its ARR to match a risk-free rate, its underfunded liabilities will increase, and employees and employers will need to contribute more to get the pension to fully funded status.  As it stands right now, most public pensions can not and will not use a risk-free ARR and can only hope that the market, which already burned them twice since 2000, will pull them out of this crisis.