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...

Tuesday, March 4, 2014

Why PSPRS is underfunded and Warren Buffet is rich

They do not call Warren Buffett "The Oracle of Omaha" for nothing.  In 1975 Mr. Buffett sent the letter posted below to Katharine Graham, the CEO and Chairman of the Washington Post.
While most of the letter details his ideas on how to invest the Post's pension assets, it is in the first five pages (which I highly recommend) of the letter where Mr. Buffett makes his most important points.  The most amazing thing about the nearly 40-year-old letter is how prescient it was, anticipating many of the problems we have today with defined benefit pensions.  I especially appreciate the straightforward and understandable manner in which Mr. Buffett writes to Ms. Graham, herself a legendary businesswoman.  Too often we trust supposed experts, whether politicians, union representatives, or investment professionals, who can not clearly explain what they do to those of us they are supposed to serve.  Here you have an obvious expert in finance, actuarial science, and human nature with a 50+ year track record of success giving clear, common sense advice to an accomplished CEO, and he does it without even a hint of condescension.
Among the important points made by Mr. Buffett are the lack of understanding of actuarial science by otherwise knowledgeable business people, the permanence of pension benefits, and the fallibility of actuaries' assumptions.  Mr. Buffett's oracular genius can be summed up in one passage:
There is probably more managerial ignorance on pension costs than any other cost item of remotely similar magnitude.  And, as will become so expensively clear to citizens in future decades, there has been even greater electorate ignorance of governmental pension costs.  Actuarial thinking is simply not intuitive to most minds.  The lexicon is arcane, the numbers seem unreal, and making promises never quite triggers the visceral response evoked by writing a check.
Remember this was written in 1975!

However the most crucial point made by Mr. Buffett is that a pension "promise" is nothing more than a cost that needs to be accountable, calculable, and payable.  If it can not be accounted for, calculated, or paid, you should be very careful when committing yourself to it.  Mr. Buffett contrasts a pension which promises to pay $500 per month for life versus one that promises to pay 1,000 hamburgers a month for life, assuming a present hamburger price of $0.50.  Mr. Buffett calculates the actuarial value of the $500/month annuity at $65,000, but writes:
You won't find an insurance company willing to take the 1,000-hamburgers-a-month obligation for $65,000 - or even $130,000.  While hamburgers equate to $0.50 now, the promise to pay hamburgers in the future does not equate to the promise to pay fifty-cent pieces in the future.
Donald Rumsfeld would probably call the future price of a hamburger a known unknown.  These known unknowns need to be controlled for to the greatest extent possible, and unknown unknowns, say a new disease that wipes out the world's beef supply, need to be eliminated completely.

This does not mean, of course, that politicians and others with a financial stake in a pension would not blithely guarantee a pension paid in future hamburgers.  After all, future costs are an abstraction, and there will always be tax revenue coming in to pay any "unexpected costs."  This is how we end up with things like immutable COLA formulas, the DROP, and unlimited pension spiking.  If these drain PSPRS, those who made the promises can honestly claim ignorance since they probably never carefully quantified in dollars the promises they made.

And I am sure they never read Warren Buffett's letter.  In case you were wondering, at the time Jeff Bezos purchased the Washington Post newspaper from the Washington Post Company last year, its pension had a $1 billion surplus.

Monday, March 3, 2014

PSPRS lawsuits and unintended consequences: Will another victory be our undoing?

I know that most people do not have much interest in reading court decisions, but many of you may find the Fields v. EORP opinion informative.  It is a 15-page PDF document that gives a history of pension legislation up to and including the implementation of SB 1609, as well as the reasoning behind the Arizona Supreme Court's decision to decide in favor of retirees and against EORP and PSPRS.

The Fields case is settled, but it is only the first of two pairs of lawsuits against EORP and PSPRS.  The still-pending lawsuits by active members of EORP and PSPRS could have even more dire financial consequences if they are decided in favor of the plaintiffs.  The Hall and Parker cases against EORP and PSPRS, respectively, seek to not only restore the old COLA formula for active members, but more importantly, they seek to reduce the employee contribution rate back to where it was before SB 1609 became law.  For PSPRS members hired before SB 1609 went into effect, this would return the employee contribution rate to 7.65% (PSPRS' current fiscal year 2014 rate is 10.35%)  and force PSPRS to refund the excess contributions over 7.65%.

Figuring for the current fiscal year, an active PSPRS member, who had $70,000 in pensionable income, will pay PSPRS 10.35% or $7,245 in contributions between 7/1/2013 and 6/30/2014.  If PSPRS was forced to refund 2.7% in excess contributions for the current fiscal year (FY), PSPRS would have to return $1,890 to that active member.  Smaller increases in the employee contribution rate in FY's 2012 (1% or $700) and 2013 (1.9% or $1,330) would bring a total refund due of $3,920.  Multiply this amount by the thousands of active PSPRS members, and you have a huge outflow of PSPRS' assets.  Based on numbers from the FY 2013 annual report, I estimate that at least $65 million in refunds would be due.  Worst of all for employers is that these higher employee contribution rates are figured into PSPRS' current amortization of its unfunded actuarial accrued liability.  If the employee contributions rates are reduced, the funding ratio will immediately drop, and employers (i.e. taxpayers) and new hires (i.e. union brothers and sisters) will have to make up the difference.  This is why the Hall and Parker cases are so important.

While I am not an attorney nor an expert in pension law, I still wanted to see if anything in the Fields decision might give some idea how the Hall and Parker cases might be decided.  The following paragraphs give some tantalizing clues as to how those cases may be decided.  I have put in boldface several passages which I think are relevant.
¶27 Our interpretation of the Pension Clause is consistent with prior cases. In Yeazell v. Copins, this Court held that an employee was entitled to have his retirement benefits calculated based upon the formula existing when he began employment, rather than a less-favorable formula subsequently adopted during his employment. 98 Ariz. 109, 115, 402 P.2d 541, 545 (1965). The Court explained that the employee “had the right to rely on the terms of the legislative enactment of the Police Pension Act of 1937 as it existed at the time he entered the service of the City of Tucson and that the subsequent legislation may not be arbitrarily applied retroactively to impair the contract.” Id. at 117, 402 P.2d at 549. As in Yeazell, Fields has a right in the existing formula by which his benefits are calculated as of the time he began employment and any beneficial modifications made during the course of his employment. Thurston v. Judges’ Ret. Plan, 179 Ariz. 49, 51, 876 P.2d 545, 574 (1994) (recognizing that “when the amendment [to retirement benefits] is beneficial to the employee or survivors, it automatically becomes part of the contract by reason of the presumption of acceptance”).
¶28 This definition of “benefit” also comports with the use of the term in other states that have similar constitutional provisions protecting public pension benefits. For example, construing a similar definition of “benefit,” New York and Illinois have also determined that benefit calculation formulas are entitled to constitutional protection.5 See Kleinfeldt v. New York City Emps.’ Ret. Sys., 324 N.E.2d 865, 868–69 (N.Y. 1975) (including the formula utilized in calculating an annual retirement allowance under the Pension Clause); Miller v. Ret. Bd. of Policemen’s Annuity, 771 N.E.2d 431, 444 (Ill. App. 2001) (holding benefit increases to be constitutionally protected). Additionally, unlike narrower protections found in other states’ constitutions, the protection afforded by the Arizona Pension Clause extends broadly and unqualifiedly to “public retirement system benefits,” not merely benefits that have “accrued” or been “earned” or “paid.” See, e.g., Alaska Const. art. 7, § 7; Haw. Const. art. 16, § 2; Mich. Const. art. 9, § 24.
 ¶32 EORP relies on Smith v. City of Phoenix, 175 Ariz. 509, 858 P.2d 654 (App. 1992), to argue that Fields had only a contingent right. In Smith, a city ordinance set the salaries of city judges at 95% of the salaries of superior court judges. Before a statutory increase in superior court salaries took effect, the city revised its ordinance to preserve the salaries for city judges at the then-existing amount. Id. at 514, 858 P.2d at 659. The court of appeals held that Smith had no vested contractual right to continued salary increases under the city ordinance, observing that his “contract of employment” did not express “that the method of calculating his salary would remain fixed throughout his term,” and “[i]ndeed, the fact that both parties knew his salary was established by a city ordinance, which was naturally subject to change by the city council, suggests just the opposite.” Id.
¶33 Smith is inapposite. Assuming the case was correctly decided, we note that it reflects the general principle that statutory provisions do not create contractual rights. See Proksa v. Ariz. State Sch. for the Deaf & the Blind, 205 Ariz. 627, 629 ¶¶11–12, 74 P.3d 939, 941 (2003). But statutorily established retirement benefits are an exception to this rule. Id. at 631 ¶21, 74 P.3d at 943. Under Yeazell, the right to a public pension on the terms promised vests upon acceptance of employment, 98 Ariz. at 115, 402 P.2d at 545, and “the State may not impair or abrogate that contract without offering consideration and obtaining consent of the employee,” Proksa, 205 Ariz. at 630 ¶ 16, 74 P.3d at 942; cf. Thurston, 179 Ariz. at 52, 876 P.2d at 575 (recognizing that a detrimental modification to retirement benefits “may not be applied absent the employee’s express acceptance of the modification because it interferes with the employee’s contractual rights”).
Paragraphs 27 and 28 would seem to indicate that the COLA formula that was in place when one was hired is considered a benefit protected by the Pension Protection Clause of the Arizona Constitution for active employees as well as retirees.  It can not be reduced without the consent of the affected employees, and any change beneficial to the employee is assumed to be accepted by the employee and also protected.  If I were betting on this, I would bet that Hall and Parker will almost certainly win this part of their cases.

The more interesting and speculative situation regards the employee contribution increases. Paragraphs 32 and 33 seem to indicate that an employee's pay is subject to change through legislative channels.  While the Court rejected EORP's use of this precedence in the Fields case, it still seems germane to the Hall and Parker cases.  I would consider a change in employee contribution rates a matter of pay and not pension benefits, and therefore, not subject to the Pension Protection Clause.  The employee contribution rate to PSPRS would seem to be no different than what an employee pays for medical insurance, and since it only affects the employee's current pay and not his end pension benefit, the contribution rate in place when an employee was hired does not appear to be protected.

The justices include a rather curious qualifier to the Smith case with the inclusion of the statement, "assuming the case was correctly decided," which they do not do for any other precedent cited.  Does this mean they think this case was decided incorrectly and should not be cited as precedent in future cases?  I do not know.  Also, the Fields case skirts the Contract Clause of the Arizona and U.S. Constitutions and really only deals with the Pension Protection Clause.  In the end, I think the Court would be very reluctant to consider employee contributions rates as a pension "benefit."  If they cited the Contract Clause to say employee contribution rates were set when employees were hired and could not be changed by the legislature, they would be opening a Pandora's Box of lawsuits over every benefit change that adversely affected an employee.

So my inexpert legal prediction would be that Hall and Parker win over the COLA changes and lose over the employee contribution rate increases.  What causes me to lose sleep at night is that if this prediction is correct, it means that employee contribution rates can be raised to whatever the legislature deems necessary.  As it stands now, the employer contribution rate can not exceed 11.65% nor can total employee contributions exceed more than one-third of the aggregate employer/employee contributions, whichever is lower.  Employers must pick up at least two-thirds of the aggregate.  For comparison, the Arizona State Retirement System (ASRS), which covers most public employees in Arizona, has a 50/50 split between employees and employers.  If the legislature had constitutional cover to raise employee contribution rates into PSPRS, could they raise them to make it an even split?  I do not see why not, especially when employees asked for this decision.  Going from a 33% share to a 50% share of aggregate contributions would increase employee contribution rates by 50%.  Our aforementioned hypothetical employee would pay an additional $3,255 to PSPRS this fiscal year if the employee contribution rate went from 10.35% to 15%.  Last FY employees paid only about 26% of the aggregate employer/employee contributions, so the potential increases are even worse than they now seem.

This is just one scenario based on a layman's reading of the Fields decision, but it is very possible that any victory by the plaintiffs in the Hall and Parker cases is a pyrrhic one.  As before, we will have to wait and see how the Arizona Supreme Court rules, and how the legislature reacts.  Stay tuned.