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...

Thursday, August 22, 2013

PSPRS and pension spiking, part II

The type of pension spiking that is occurring in Phoenix, which appears to be in clear violation of state law since it uses lump sum payouts in final pension calculations, is not the only type of pension spiking that impacts PSPRS.  The more common type of pension spiking occurs when a worker uses other methods to increase the final average salary used to calculate his pension benefit.

For all workers hired before January 1, 2012, the final pension benefit is calculated based on the average of their high three-year salary period.  (For those hired on January 1, 2012 or later, the calculation is based on the high five-year period.)  This means that a worker interested in maximizing his pension can utilize pay enhancements like overtime and incremental sick leave sellback programs to increase his average salary.  These types of enhancements appear to fit within state law as they do not involve lump sum payments.  Workers are free to work overtime as needed by their employer, and incremental sick leave sellback programs allow workers to sell back portions of their accrued sick leave while they are still working.  This means  regular payments are made during a participant's career, not as a lump sum payments at the end of his career.

So what effect does this type of pension spiking have on PSPRS' finances?  Using the same type of example as in the previous post, we can use a Tucson Fire Department (TFD) member who retires or DROP's after 25 years and will have a final pension benefit calculated at 62.5% (a 2.5% pension multiplier for each year of service) of the average of her high 3-year salary period.  If through a combination of selling back sick leave and working overtime she is able to increase her average annual salary of $70,000 by 10%, she will earn an extra $7,000 per year.  This would translate to an increase in her annual pension benefit of $4,375.  If she lives another 20 years she will reap an extra $87,500 in benefits.

If we use the current combined contribution rate for TFD of 57.12% (10.35% employee and 46.77% employer), each year PSPRS would receive approximately $3,998 in additional contributions.  If this amount was paid into PSPRS on a biweekly basis this would equal approximately $154 every two weeks.  This steady $154 paid every two weeks, compounded daily at 8% annual interest, would grow to $13,597 after three years.  This $13,597 compounding at the same interest rate would increase to $67,335 after another 20 years.  This means that 20 years into this member's retirement PSPRS would actually see a deficit of $20,165. 

Using different interest rates we can see where the breakeven point for PSPRS is when it comes to spiking:

Interest Rate          Balance at 20 Years       Gain or (Loss)
     6.00%                    $43,742                      ($43,758)
     7.00%                    $54,267                      ($33,233) 
     7.85%                    $65,191                      ($22,309)
     8.00%                    $67,335                      ($20,165)
     9.00%                    $83,551                       ($3,949)
     9.25%                    $94,794                         $684
    10.00%                   $113,869                      $16,177

PSPRS does not break even in this case of pension spiking until the interest rate reaches around 9.25%.  7.85% rate is PSPRS' expected rate of return (ERR) for the current fiscal year.  So while this case of pension spiking may not appear as bad that occurs when lump sum payments are used, it still takes a toll on PSPRS' finances to the tune of $22,000 at the current ERR.  It is also very important to remember that of the additional $3,998 paid each year into PSPRS, the employee paid only about $725, the taxpayers picked up the other $3,273.  All in all, the employee paid an extra $2,175 to receive an additional $87,500 in benefits over 20 years.

These numbers are projected out from simple estimates, but it again shows how pension spiking blunts the power of compounding.  TFD's high contribution rate tells us that they are already badly underfunded, so a pension spike like this only makes their situation worse.  For anyone interested in running numbers, Bankrate has this compound interest calculator that I used for computations.

While this case may not be as egregious as those in Phoenix, it is still harmful.  This case would be much worse if Tucson taxpayers were not already paying such a high contribution rate.  While an individual case may not seem so bad, when combined with thousands of others, you start to see the problem.  If you think this problem has not been noticed by those able to change the law, you would be wrong.  More on that in the next post.

No comments:

Post a Comment

Relevant comments are welcome, but please adhere to the following rules:

1. No profanity or vulgarity.
2. No spam or advertising.
3. No copyrighted material may be posted unless you are the copyright owner.
4. Stay on topic.
5. Disagreement is fine, but please avoid ad hominem attacks.

Comments reflect the views of the authors alone, and do not reflect the opinion of this website.