PSPRS and its broken COLA system may be worse than you think

In recent posts I discussed the Professional Fire Fighters of Arizona (PFFA) reform plan to PSPRS.  If you have read those posts, it is clear that the PFFA plan is a non-starter which provides zero improvement over the reforms implemented by SB 1609.  However, the cost of living allowance (COLA) reforms of SB 1609 have been reversed for retirees and are virtually certain to be reversed for all PSPRS members hired before 2012.  This leaves us with an unsustainable COLA system that will remain in place for decades.  So what is to be done about COLA's?

A Little Backstory

Obviously, this is a difficult question to answer, so the best place to probably start would be at the beginning.  I have mentioned this several times before, but we have to remember that what we are discussing are not really cost of living allowances.  PSPRS confuses the issue by interchanging the term COLA and permanent benefit increase (PBI) in its documentation.  PSPRS does not increase retiree benefits based on any measure of inflation like the consumer price index (CPI), which tracks the prices of a basket of goods, to raise Social Security benefits annually.  The PBI awarded by PSPRS is based strictly on a highly flawed excess earnings model, and recent PBI's have been much more generous than Social Security.  This can be seen in the post here that looks at PBI's since 2000.  Another way that PSPRS differs from Social Security is that PSPRS awards a flat monthly dollar amount not a percentage of the existing benefit.  This helps those with lower retirement benefits as it represents a higher percentage increase than those with larger benefits.  As a final note, the Arizona Revised Statutes also do not mention the term COLA and uses the term "permanent increase in the base benefit."

The flawed excess earnings PBI model was based on an even more flawed and misguided notions. The excess earnings model could only have been designed and advocated by those who believed that PSPRS could never become underfunded, that it could never suffer large investments losses, or that the bill for systemic underfunding of benefits through bad policies and programs would never come due.  I suppose these notions came about from an extended bull market from the early 1980's until about 2000, a textbook case of financial short-sightedness.  This was all capped off with the passage of Proposition 100, which added a "pension protection clause" to the Arizona Constitution, in 1998, and the flawed excess earnings model became permanent.

What we have seen over the past 13 years is an erosion of PSPRS' aggregate funding ratio from a high of 126.9% in fiscal year 2000-01 to 57.1% in fiscal year 2012-2013.  This erosion has been steady and unrelenting yet, except for the brief interlude after SB 1609's passage and the resolution of the Fields case, PBI's continued to be paid, and with the Fields decision, retroactive PBI's have recently been paid out.  The most powerful and most expedient way for PSPRS to increase its funding ratio is through the compounding of market returns.  Legend has it that no less than Albert Einstein said that compound interest is the most powerful force in the universe.

Let's see exactly how powerful this would be with some calculations done with the compound interest calculator available here.  We will use two annual excess earnings of  $100 million and $200 million to show the difference to the balance in PSPRS' underlying fund under scenarios where half ($100 million) of the amount over 9% goes to the PBI fund (as in the current excess earnings model) fund versus all ($200 million) earnings remaining in PSPRS' underlying fund (as in the SB 1609 model with PSPRS under 60% funded).  $200 million compounded monthly for five years at the current ERR of 7.85% would earn the PSPRS' underlying fund about $48 million more than $100 million compounded at the same rate.  This $48 million is in addition to the $100 million that was never placed in PSPRS' underlying fund in the first place, so instead of having an additional $296 million in it, the underlying fund has only an additional $148 million, with the remaining $148 million in the PBI fund.  Of course, PSPRS is not actually losing the $148 million total since it exists in a different account that PSPRS controls, but funds in that PBI account do not count toward PSPRS' funded ratio since those funds can only be used to pay PBI's.

While this is a simplistic scenario it illustrates how destructive the current excess earnings PBI model is.  The millions not going into PSPRS' underlying fund mean higher contribution rates for employers, and consequently, lower pay and benefits for current employees and diminished services for citizens.  Keep in mind that the current excess earnings PBI model is even worse than it appears at first glance because excess earnings are paid into the PBI fund regardless of PSPRS' past performance.  Using the previous examples, PSPRS could suffer a cumulative loss during the five year period but still pay excess earnings into the PBI fund because some individual years may have exceeded a 9% return.  In this case, not only does PSPRS lose an opportunity to help clear its unfunded liability, it actually increases its unfunded liability.  We do not need a compound interest calculator to know that this is not a sustainable method of paying PBI's. 

A Closer Look at PBI's


For PSPRS retirees, the payment of PBI's has been a great deal.  The most recent PBI retroactive for fiscal year  (FY) 2014 (July 1, 2013 to June 30, 2014) was $121.19/month or $1,454/year.  The FY 2013 PBI was $159.13/month or $1,910/year.  For someone with a monthly retirement benefit of $4,000/month, the PBI would mean a percentage increase of 3.0% for FY 2014 and 4.0% in FY 2013.  The average PSPRS pension for FY 2013 was $49,571/year.  The following shows the COLA's paid by the Social Security Administration over the past 40 years:

7/1975: 8.0%     1/1985: 3.5%    1/1995: 2.8%     1/2005: 2.7%
7/1976: 6.4%     1/1986: 3.1%    1/1996: 2.6%     1/2006: 4.1%
7/1977: 5.9%     1/1987: 1.3%    1/1997: 2.9%     1/2007: 3.3%
7/1978: 6.5%     1/1988: 4.2%    1/1998: 2.1%     1/2008: 2.3%
7/1979: 9.9%     1/1989: 4.0%    1/1999: 1.3%     1/2009: 5.8%
7/1980: 14.3%   1/1990: 4.7%    1/2000: 2.5%     1/2010: 0.0%
7/1981: 11.2%   1/1991: 5.4%    1/2001: 3.5%     1/2011: 0.0%
7/1982: 7.4%     1/1992: 3.7%    1/2002: 2.6%     1/2012: 3.6%
           *               1/1993: 3.0%    1/2003: 1.4%     1/2013: 1.7%
 1/1984: 3.5%     1/1994: 2.6%    1/2004: 2.1%     1/2014: 1.5%

* Change from a fiscal to a calendar year

The following show PBI's paid by PSPRS and their percentage of the same $4,000/month retirement benefit:

2004: $111.90/2.7%    2008: $134.34/3.4%  2012: $153.06/3.8%
2005: $116.82/2.9%    2009: $138.60/3.5%  2013: $159.13/4.0%
2006: $121.76/3.0%    2010: $146.74/3.7%  2014: $121.19/3.0%
2007: $127.06/3.2%    2011: $152.84/3.8%  2015: TBD

Comparing the two charts shows that since 2004 PSPRS has exceeded the COLA percentage paid by the SSA in all but two years, and in two years when SSA paid nothing, PSPRS paid 3.5% and 3.7%.   Under the current excess earnings formula, retirees are eligible for a PBI of up to 4% of the average normal retirement benefit, so it is possible that PBI's could be less than the rate of inflation.  However, with inflation kept pretty tame over the past 30 years, PBI's have been a boon for retirees, especially when we note that the average annual pension in FY 2004 was only about $35,000/year versus $49,571 in FY 2013.   Someone with a $3,000/month pension in 2004 would have seen a 4.0% increase in his pension that year, and in 2014 would now be getting a monthly benefit of $4,484, a nearly 50% increase in his benefit check in just 11 years, which makes his annual pension $4,000 higher than the FY 2014 average.  Using the SSA's COLA percentages would give us a monthly, inflation-adjusted benefit of $3,915, $570 less than what PSPRS actually awarded

Inflation

I would hope that everyone would agree that robbing the underlying PSPRS fund to pay PBI's will hurt everyone, whether retired or not, even if it has been, up until now, a real good deal for retirees.  SB 1609 addressed some of the problems by tying PBI's to PSPRS' funded ratio and raising the threshold for paying PBI's.  Of course, this is now a moot point since that part of SB 1609 has been ruled unconstitutional.  So where does this leave retirees?

Let's start by taking a few steps back and looking a little closer at some economic issues, particularly inflation.  When one considers an investment, it is necessary to determine the real interest one is earning.  This is simply the nominal interest rate minus the inflation rate.  This is equally true when considering an increase in pay as someone getting a 2% pay raise in an economy with 3% inflation is actually poorer (but of course better off than if he had gotten no raise).  For a retiree, whose only source of income may be his retirement benefit, knowing the real interest rate is very important.

If we look at the SSA chart again, we see a seven-year period between 1975 and 2002 where inflation was quite high, reaching 14.3% in 1980.  As stated before the current excess earnings model for PBI's allows for a maximum PBI of 4% of the average normal benefit.  Translated into actual dollars this could be more or less than 4% of an individual's benefit, depending on whether the individual's benefit was north or south of the average.  If we again use our $48,000/year pension and calculate a PBI benefit at the maximum 4% per year for four years, that annual pension would be $56,153 at the end of that four-year period.  It gets interesting if we begin to contemplate the possibility of inflation exceeding 4% per year.

If inflation is 6% per year, a retiree would find himself $10,597 poorer (with annual losses of $960, $2,016, $3,175, and $4,446) at the end of the four-year period based on his -2% real interest rate with a pension 7.3% lower than the first year (having only $56,153 available but needing $60,599 to keep up with the increased cost of goods).  At 8% inflation, he would be $21,613 poorer with a pension 14.0% lower than the first year.  At 10% inflation, he would be $33,061 poorer with a pension 20.1% lower than the first year.  We could go on with higher inflation rates or longer periods of time, but I think that the insidious effect of inflation is quite clear in these examples.

If you are a retiree, high inflation is your kryptonite.  Neither the current excess earnings model or SB 1609 allow for a PBI higher than 4%, and the PFFA proposal limits PBI's to 2%.  The danger here is the same one that has afflicted PSPRS for years: a sense of complacency that everything will continue on as it always has.  High returns will continue indefinitely--wrong.  Equities have always made us money--wrong.  Serious market crashes can be prevented--wrong.  Inflation can be controlled--right?  I don't know about the last one, but the track record has not been very good on the others. 

My final point on inflation deals with PSPRS itself.  It may seem like PSPRS would also suffer with inflation, but in fact under all the current PBI scenarios, inflation would be helpful in returning PSPRS to financial health.  Inflation benefits debtors who can pay off debts with cheaper dollars.  If inflation were to take off, PSPRS would most likely see an increase in market returns on its investments.  Wage inflation for employees and higher tax revenue coming to employers would bring in more contributions.  Higher market returns and greater contributions would go a long way to erasing PSPRS' unfunded liability, but retirees would be limited to the 4% or 2% PBI's. I have already expressed my disdain for the PFFA pension reform proposal as a current employee, but retirees should look askance at it as well when we consider the potential for harm to those on a fixed income.  The 2% limit on PBI's proposed by the PFFA were to be embedded in the Arizona Constitution making them nearly impossible to alter.

 Conclusion

So the past is no guide to the future.  In years of low inflation PSPRS was paying PBI's that exceeded inflation, yet PSPRS has no mechanism for dealing with extended periods of high inflation.  This is the legacy of treating PSPRS as some kind of magic money machine that only has to be programmed with the right formulas to keep paying out in perpetuity.  The next post will have some modest proposals to deal with this.