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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, December 16, 2014

What PSPRS can learn from the Arizona State Retirement System (ASRS)

If you want to see an illustration of what is wrong with PSPRS, check out this article, "Public workers, employers to pay less for pension plan," by Craig Harris from the December 5, 2014 edition of the Arizona Republic.

Mr. Harris writes about the fiscal year 2016 contribution rates and COLA's for employed and retired members, respectively, of the Arizona State Retirement System (ASRS).  ASRS is the largest defined benefit pension system in the state.  It basically covers any non-federal government worker in Arizona who does not work in public safety, corrections, or as an elected official or does not work for the cities of Tucson or Phoenix.  This includes the three state universities, community colleges, school districts, and state, county, and municipal governments.  It is a huge system with assets about four times that of PSPRS.

ASRS is often held up as an exemplar when compared to PSPRS, and ASRS is a stick with which critics like to beat PSPRS.  This has especially been the case over the past two years when so much negative attention was focused on PSPRS' former Administrator and staff.  This is not an unfair comparison because it is funded at almost 77%, significantly better than PSPRS' 49% funding ratio, and returned 18.6% last fiscal year versus 13.2% for PSPRS.  However, Mr. Harris gives some important details about ASRS that can give us some some understanding as to why ASRS is in such better shape than PSPRS that goes beyond any difference in the funds' respective management.

The article states that ASRS' employers and employees will see a drop in their contribution rates next fiscal year.  The drop is small from 11.48% to 11.35% but shows that ASRS is moving in a positive direction.  This also means that ASRS employees will pay less next fiscal year than PSPRS employees, who will see their contribution rate increase (and finally top out) at 11.65%.  As far as I know, all non-public safety employees in Arizona must also pay into Social Security, which is fixed at 6.2% apiece for the employer and employee

Like Social Security, ASRS equally splits the annual required contribution (ARC) between the employer and employee.  This is starkly different from PSPRS where employees will be capped at 11.65% next year, but employers have an open-ended commitment to the remainder of the ARC.  For next fiscal year, PSPRS has an average employer contribution rate of  over 41%.  Individual employer rates can be much worse, such as that of the City of Tucson which will have contribution rates in the mid-60% range for both its police and fire departments.  This means that the City of Tucson will have to pay over $0.60 for every dollar of pensionable income paid to its police officers and firefighters.

The importance of equally splitting contribution rates cannot be overstated.  It is the best barometer employees have to measure the health of their pension system and receive forewarning that a problem is brewing.  Politicians are reactionary and will act only after the problem becomes too big to ignore.  The higher ranks of public safety unions tend to be comprised of more senior members who have little incentive to advocate for proactive changes that may adversely affect their own retirements.  Therefore, a rising contribution rate can work as an early warning system for rank-and-file employees when past and/or current policies begin to show deleterious effects on PSPRS and, at the very least, force consideration of corrective actions.

PSPRS was about 127% funded on June 30, 2001.  PSPRS was 49.2% on June 30, 2014.  ASRS was 113% funded on June 30, 2001 (but had actually peaked at 120% funded the previous fiscal year) and was 77% funded on June 30, 2014.  During this 14-year period, ASRS employers and employees saw contribution rates increase from 2.49% (FY 2002) to 11.35% (FY 2016).  PSPRS employees had a fixed rate of 7.65% until fiscal year 2012 when it began to increase incrementally, reaching the maximum rate of 11.65% in fiscal year 2016.  The average PSPRS employer rate increased from 4.21% (FY 2002) to 41.08% (FY 2016).  We see in ASRS a steady increase in the contribution rate that was shared equally by employer and employee.  ASRS began with a lower contribution rate than PSPRS and raised it to meet funding shortfalls and now is in a position to begin lowering it back down.  On the other hand, PSPRS' fixed employee contribution rate hid rapidly escalating pension shortfalls from employees, who are now in a worse financial position than ever as increased employer contribution rates eat into their current wages.

As well as having a more transparent method of allocating ARC's, ASRS has a stricter COLA policy.  Mr. Harris writes:
For a permanent benefit increase to kick in, the trust must produce a rate of return in excess of 8 percent — the assumed rate of investment growth — for 10 years and generate a pool of excess earnings.
I am not sure how ASRS determines when there is "a pool of excess earnings," but ASRS, unlike PSPRS, has a proper understanding of COLA's.  We will not go into the details of the Fields decision again here, but even those whom the decision benefited must acknowledge that it is bad for all PSPRS members, working or retired.  It is simple common sense that a pension system cannot pay COLA's when it is underfunded, especially when it is less than half funded.  Paying COLA's to retirees from an underfunded pension is simply consuming the seed corn that is necessary to bring PSPRS back to financial health.  As in the case of employees and contribution rates, the real and pernicious damage caused by the pre-SB 1609 COLA formula was hidden from retirees, despite the potential financial risk to themselves and the certain financial burden it places on those that follow them in public safety careers.

While ASRS and PSPRS started at the same place in 2001, their financial fortunes have diverged dramatically over the past 14 years.  Both systems had to endure the dot.com crash and Great Recession, yet ASRS is in such a better position than PSPRS.  How did this happen?  Even if we attribute some of this to the systems' respective management teams, we cannot deny that PSPRS' problems went unaddressed for much longer than ASRS'.  ASRS was increasing employer/employee contribution rates and cutting retiree COLA's well before the Great Recession.  The legislature and public safety unions did nothing about PSPRS until well after the market crashed for the second time in the decade, and the state firefighters' union was even denying any reform was necessary at the time SB 1609 was passed, though they are now advocating their own bad reform proposal.

Obviously, ASRS is better designed than PSPRS and already has mechanisms in place to better allocate costs between workers, retirees, and employers.  These mechanisms makes financial sense, but more importantly, they ensure that every stakeholder is aware of and bears the pain of pension funding shortfalls.  This is something that is sadly missing from PSPRS.  If employees saw their checks shrinking year on year and retirees saw their COLA's diminished or eliminated, it would have forced them to look more critically at the policies that were slowly depleting PSPRS, and hopefully, do something about them before they spiraled completely out of control.