Notes on a (PSPRS) scandal

The Arizona Republic leads it web page today with this story by Craig Harris: Pension trust in federal inquiry.  The pension trust in question is PSPRS.  The article implies a suspicion of wrongdoing in how PSPRS valued its real estate investments.  For some background, the following articles by Randy Diamond in Pensions and Investments* provide good information about what this is all about:

• Hacking says law firm hired to investigate Arizona Public Safety staff's complaint (7/19/2013)
• Appraisals become issue in Arizona's real estate investments (9/2/2013)
• Another Arizona Public Safety investment staffer resigns (9/11/2013)
• Arizona Public Safety suspends investment staff bonuses (9/26/2013)
• Arizona Police Association requests criminal investigation of PSPRS investment cover-up  (9/27/2013)
• Arizona Public Safety Fund needs to change valuation on Desert Troon portfolio - auditor general (12/6/2013)

 * The website may only allow you to look at two articles before asking you to register.  Closing your browser, clearing your history, and relaunching it seems to allow you to look at two more articles.

There is also this Auditor General's Letter and this PSPRS' Official Response Letter:  Both letters contain a lot of accounting jargon relating to how real estate investments should be valued, but as I read them, the main issue was that PSPRS and Desert Troon were using values that were based on "future development plans" for their property, rather than more conservative measures of current market value.  Once more appropriate valuations standards, based on comparable sales, were used a new valuation was calculated showing a $20 million overvaluation at the end of fiscal year 2013.

At this stage, it is impossible to tell where this is going, but one thing stands out.  The initial Ernst & Young (EY) valuations stated that PSPRS was overvaluing its Desert Troon real estate portfolio by $89.9 million and $82.2 million at the ends of fiscal years (FY) 2012 and 2013, respectively.  However, when EY redid the valuations using the standards required by the Arizona Auditor General, the new valuation for FY 2012 showed only a $24.7 million dollar overvaluation, and the new valuation for FY 2013 actually showed a $4.4 million undervaluation.  These new EY valuations (using comparable sales) are closer to Desert Troon's own valuations than EY's initial valuations.  The initial EY evaluation was undervaluing the Desert Troon portfolio by $65.2 million for FY 2012 and $86.6 million for FY 2013.

PSPRS must follow the FASB and GASB accounting standards, and the Auditor General reiterated that in its report.  The Auditor General did not suggest any wrongdoing, and the different valuations done by the same auditor show that appraising an asset like the Desert Troon portfolio is difficult and can vary wildly depending on the evaluation criteria.  Desert Troon's own valuation using projected discounted cash flows based on future development plans is not permissible according to FASB and GASB and should not have been used, but it ended up being closer to the final, accepted valuation of the Desert Troon portfolio than EY's initial valuation.  Maybe this was just luck, or maybe Desert Troon has the expertise and experience to evaluate the properties it owns and manages.

From my vantage point way on the outside, I am not seeing where there is any wrongdoing.  A bad decision, though one approved by the Board of Trustees, perhaps, but with full transparency and no cover-up.  Of course, this has all the trappings of a scandal: resignations, missing documents, lawyers, and federal agents handing out subpoenas.  We will have to wait and see what happens, and whoever has to go through the three million pages of financial documents has my sympathy.

The Arizona Public Safety Personnel Retirement System (PSPRS) Fiscal Year 2013 Consolidated Annual Financial Report

Following are some of the key figures from the Arizona Public Safety Personnel Retirement System's fiscal year (FY) 2013 Consolidated Annual Financial Report dated December 12, 2013:

1. The aggregate funding ratio dropped from 58.6% to 57.1%.  (Note: each separate entity has its own funding ratio and contribution rate, but the rate of return is the same for all entities.)  This is particularly significant for retirees because the new COLA formula now has a minimum funding ratio threshold in addition to a minimum rate of return.  These minimum thresholds are a 60% funding ratio and a 10.5% rate of return
2. The aggregate employer contribution rate will increase to 32.54% from 30.44% in FY 2015, which begins July 1, 2014.
3. PSPRS had an annual rate of return of 10.64% for FY 2013 versus -0.8% for FY 2012.  This beat the benchmark rate of return of 10.08%.  They call this 10.64% rate of return "far better-than-expected," which I would consider a bit of an exaggeration since they bested the  benchmark rate by only 0.58%.  While PSPRS has an expected rate of return (ERR) of 7.85%, which was bettered by 2.8% and should not be dismissed since any amount over the ERR works at shrinking the unfunded liability, the benchmark is the more important number because it shows if their investment strategy is working.  While the S&P 500 increased from 132.16 1362 to 158.78 1606 (20.1%  17.9% increase) and 10.64% may seem like underperformance in comparison, the new investment strategy implemented by PSPRS is meant to balance risk minimization with return on investment and seems to have worked as planned last FY.
4. As of June 30, 2013, there were a total of 10,159 pensions, made up of normal service, disability, spousal, and child (with guardian) pensions, being paid by PSPRS.  Of the 7,44 normal service pensions the average annual pension is $52,592.  1,140 disability pensions average $41,527 annually.  1,252 spousal pensions average $41,645.  53 children (with guardian) pensions average $26,482.
5. Of the 10,159 pensions being paid, 1,058 (10.41%) range from $24,012-$36,000 per year, 4,499 (44.29%) range from $36,012-$48,000 per year, 2,510 (24.71%) range from $48,012-$60,000 per year, and 1,154 (11.36%) range from $60,012-$72,000 per year.  There are 806 making more than $72,000 per year in retirement. 132 make $24,000 or less per year.
6. As of June 30, 2013, there were 18,436 active members of PSPRS, 10,159 retirees/beneficiaries, and 1,482 in the Deferred Retirement Option Plan (DROP).  Active members decreased by 106, retirees/beneficiaries increased by 357, and DROP participants decreased by 14 compared to last FY.  This means that 18,436 are paying into PSPRS, while 11,641 are not (note: some DROP participants continue to pay into PSPRS but will be refunded their contributions with interest when they cease employment).  This is a ratio of 1.58 active contributing employees to each retired or DROPped non-contributing individual.  This ratio was 1.64 at the end of last FY.
7. The average annual salary of the 18,436 active members is $74,344 versus $72,767 last FY.
8. The average age at retirement for a normal service retirement is 51.3 years, and for a disability retirement it is 43.8 years.
9. Employees paid $127,363,000 into PSPRS last FY.  Employers paid $380,852,000 into PSPRS last FY.

I would recommend that all PSPRS members, at the very least, read (PDF) pages 9-15 of the Introductory Section of the FY 2013 CAFR, as well as their own employer's actuarial report.  The CAFR reemphasizes the detrimental effects the current lawsuits will have on PSPRS' finances if any or all of them are decided in favor of the plaintiffs, but my favorite part is this confidence-inspiring passage in the Board of Trustees' letter:

While today the PSPRS Plan is far better positioned to weather the volatility of the financial markets and perform up to expectations, over the long term, there are still serious risks over which we, as a Board of Trustees, have no control, such as the fiscal grid-lock at the federal level in the U.S., economic malaise and financial market stagnation in Europe, and declining rates of economic growth in Asia and emerging markets of Africa, Latin America, the Middle East, and South and Southeast Asia.  These risks are simply a consequence of the reality that Plan assets must be invested in the financial markets and cannot be totally immunized against the consequences of what happens when those financial markets perform poorly, as was demonstrated in FY '08 and FY '09 and again in FY '12.

 . . . And don't forget about what will happen if Goldfinger irradiates all the gold stored in Fort Knox.  Joking aside, it is actually refreshing to see this type of honesty and advance warning about the potential risks ahead for all of us.  The Trustees do not speculate about what may happen to PSPRS if any of the aforementioned risks precipitate another financial crisis; they leave it up to the reader to stay informed and be prepared.  That seems like a good idea to me.

PSPRS lawsuits: Can other states give us an idea how the Arizona Supreme Court will decide?

As we all wait for the Arizona Supreme Court to rule on the Fields case, which is challenging the SB 1609 reforms made to PSPRS' COLA formulation, it might be interesting to see how courts in other states have ruled on the issue.

This article by the Institute for Illinois' Fiscal Sustainbility has a table showing nine states, including Arizona, where lawsuits have challenged changes to state pension COLA's.  While it would be enlightening if there was a clear consensus as to whether COLA changes were legal and constitutional, there unfortunately is not.  Of the nine cases, only Arizona and Washington have had court cases decided in favor of plaintiffs opposing the COLA changes.  Plaintiffs in five states lost their cases when courts ruled that COLA's could be reduced.  Two cases are still pending and have not had any rulings issued yet.  Of the seven that have had a court ruling, three are being appealed in their respective state Supreme Courts and one is being appealed in federal court.

The cases in these different states have no bearing on how the Arizona Supreme Court will rule as each state has its own constitution and is not bound by precedence in any other state.  So while this may not help us read the tea leaves on how the Arizona Supreme Court will rule, there are a couple of points that can be taken away.  It appears that COLA lawsuits based on the violation of standard constitutional principles, such as the contracts, takings, and due process clauses, do not carry much weight.  Only in Washington did a state rule in favor plaintiffs over such standard constitutional principles.  Remember that Arizona has a pension protection clause that is the main point of contention since it expressly states that "public retirement system benefits shall not be diminished or impaired."  I have stated before that I believe retirees who were retired before SB 1609 went into effect have a clear cut case based on the pension protection clause.  However, I also thought that there would have been a quick decision in their favor, so it is anyone's guess as to how they will rule in the Fields case.

Another interesting point deals with the case of Maine.  Their case was heard in federal court and was dismissed because "retirees did not prove a contractual right to COLA's."  This case is being appealed to the 1st U.S. Court of Appeals.  I do not know why this case was heard in a federal rather than a Maine state court, but it shows that federal courts may be no more sympathetic to retirees than state courts have been in lawsuits over standard constitutional principles.  This is important since many pension issues may eventually have to be decided by federal courts.

Stay tuned.