Some thoughts about Proposition 487, the pension reform ballot measure in Phoenix

Reporter Dustin Gardiner had an excellent article entitled, "Fact Check: Will Phoenix pension reform save money?," in the October 15, 2014 Arizona Republic.  If passed this November, Proposition 487 would close the city of Phoenix's defined benefit (DB) pension plan to new employees.  New employees would be placed in a defined contribution (DC) retirement plan, like a 401(k), 403(b), or 457(b) plan, while current employees would remain in the DB plan.  The Phoenix DB pension is one of the six major public DB pension plans in Arizona, along with PSPRS, the Corrections Officers Retirement Plan (CORP), the Elected Officials Retirement Plan (EORP), Arizona State Retirement System (ASRS), and the City of Tucson's DB pension.  EORP's DB plan is already closed to new employees.  Last year Tucson had Proposition 201, a ballot measure similar to Proposition 487, ready for the November 2013 ballot, but a lawsuit tied up the measure in the courts and it never went before the voters.  Neither the Phoenix or Tucson measures would affect new public safety employees.

Mr. Gardiner does an excellent job of explaining the financial arguments, and his conclusion as to whether it will save money is "it depends."  The measure includes other money-saving provisions that are not certain to be enforced by the city council and/or are able to withstand any legal challenges.  For the record, the Arizona Republic has officially endorsed Proposition 487.

Proposition 487 will be a good gauge of voter sentiment, so I am very interested to see if and by how much it does or does not pass.  Depending on the result, it also has the potential to lead to some good or bad reforms to PSPRS.  There will be much more to talk about if it does pass.  In the meantime, here are a couple of points:

It's all about the legacy costs.  Despite all the rhetoric, it is virtually impossible that Proposition 487 costs more than it saves in the long run because it permanently ends the open-ended commitment that taxpayers have to City of Phoenix employees/retirees.  With a DC plan, the City ends its financial obligation to an employee once that employee retires, and the City is not subject to unseen costs that could last for decades.

While Tucson voters did not get a chance to vote on pension reform last year, the City of Tucson changed (with virtually no opposition) a retiree benefit four years ago that will permanently save it millions of dollars.  Starting in 2011, the City stopped paying a percentage of the health insurance premiums of non-Medicare-eligible retirees and began paying them a flat subsidy instead.  In the current year, the monthly HMO premium for a retiree, who retired before 2011, and a spouse is $250.  If the same employee had retired in 2011 or later, he would pay $625.  This $4,500 in annual costs, times however many years until he becomes Medicare eligible, is now permanently shifted from the City of Tucson to the employee.  Even more importantly, it makes costs more manageable because now the City can plan and budget for subsidies rather than be at the mercy of unknown future insurance costs that can go significantly higher.

In the same manner, matching contributions by the City of Phoenix into employees' DC accounts can be planned for and budgeted.   They can be increased or decreased depending on prevailing economic conditions, and there are no unforeseen costs waiting in the future to decimate the City's finances.

Current employees provide a benefit to a city.  Roads, buildings, and sewage treatment facilities provide a benefit to a city.  Programs that make a city safer, cleaner, or attract more jobs benefit the city.  Legacy costs for retiree healthcare and pensions do nothing for a city, except make paying for all the other beneficial things more difficult.

Do employees use the power of math for good or evil? According to its 2013 annual report, the City of Phoenix Employees' Retirement System (COPERS) uses a point system where an employee becomes eligible to retire when the combination of his age and years of service equals 80.  Benefits are calculated at 2% per year of their final average salary for up to the first 32.5 years of service with lower multipliers for years past 32.5 years.  Employees contribute 5% of gross pay toward their retirement. Note: COPERS went to a two-tier system some time after the 2013 report. Tier 2 members split the annual contribution to COPERS equally between themselves and the City, making the contributions rates for Tier 2 employees much higher than Tier 1 employees.

With an 80 point minimum, an employee starting at 24 years of age could retire at 52 years of age with an annual retirement benefit of 56% of his final average salary.  I used a spreadsheet to calculate for an employee that started his career at $35,000 per year with 3% wage inflation for each year.  His final high three-year average salary would have been a little over $75,500.  Multiply this by his 28 years of service by the 2% per year multiplier, and you get an annual retirement benefit of $42,280 or about $3,523 per month. 

The spreadsheet got a little more complicated when I calculated his total contributions.  Using the same 3% annual wage inflation with 26 annual pay periods at the 8.0% expected rate of return (ERR) compounded every two weeks, I show the total contributions paid by this employee paying 5% out of each biweekly checks growing to $230,733 when he retired.  (The employee paid a little over $75,000 in real dollars and 28 years of interest took care of the balance.)

An annuity calculation at Bankrate.com shows that this employee would need over $483,000 to get $3,523/month in income using the same expected rate of return of 8%. Even if the City had matched the employee's 5% annual contribution, he would be over $20,000 short of what was necessary to have enough saved to pay the expected lifetime income promised.  However, I think that most people would agree that $20,000 is a reasonable margin of error and would accept the argument that a public DB pension is a fair and feasible benefit that uses professional management and pooled resources to get a better deal than the employee could get investing on his own.

I am sure that the reader see several problems here, most obviously with actuarial assumptions including ERR, life expectancy, and wage inflation.  Changes in these will make all the final numbers change.  This also does not take into account things like spousal death benefits that may add years to the benefit payment and future COLA's.  These actuarial assumptions could, of course, change in a way that is beneficial to the pension's finances, but this is not likely to be the case with the current economy.

A more important point I want to make here regards pension spiking.  Using all the same data, if our hypothetical employee was able to raise his average compensation for his last (high) three years by $10,000, he would raise his final salary to about $86,115 and his retirement benefit to about $48,224 or $4,018 per month.  However, total contributions with interest would only increase by $1,793 from $230,733 to $232,526.  With the employer's 5% matching, we get $465,502 total paid in for this employee.  This is still less than what is required to pay the non-spiked pension, but what is our new annuity calculation?  At 8.0% ERR for 30 years, the cost to purchase an annuity for the spiked pension increases $68,000 to over $551,000.  Spiking the pension by $5,000 per year in the high three years would increase the annuity cost by over $54,000; spiking the pension by $15,000 per year in the high three years would balloon the annuity cost by $118,000.  Just a small change in the employee's final three years of salary makes for big changes in the cost of the employee's retirement.

The unforgiving nature of compound interest shows that there is no shortcut to retirement income.  The math is simple.  You have to save X in order to receive Y over your retired life.  If enough employees lowball X and/or highball Y, you will eventually have a pension system in financial trouble.  When any employee, not just high earners, spikes his pension, he slowly chips away at the foundation of his own retirement system.  Yet those who should be most concerned about pension spiking are doing nothing about it.  How do you stop pension spiking if elected officials show a lack of motivation in dealing with it and employees think that it is okay?

This November we will see if Phoenix voters have an idea.