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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...

Wednesday, April 29, 2015

Belling the PSPRS cat: a fable brought to you by the League of Arizona Cities and Towns PSPRS Pension Task Force

Back in February, I attended one of the PSPRS employer seminars.  It was among one of several that PSPRS and the League of Arizona Cities and Towns PSPRS Pension Task Force ("the Task Force') put on in different locations throughout the state.  The handouts from these seminars are available here at the Task Force website.

The seminar was broken into two parts, the first part presented by PSPRS and the second by the Task Force.  The PSPRS was handled mostly by PSPRS' Acting Administrator Jared Smout and covered a broad range of topics, ranging from general discussions about pensions and PSPRS to more specific discussions about the causes of PSPRS' underfunding, COLA's, and the lawsuits challenging SB 1609.  I was interested in two particular issues when it came to the PSPRS presentation.  The first was what is the status of Hall v. EORP (CV2011-021234), which is challenging the SB 1609 changes to the COLA formulation for EORP members who were still active when SB 1609 became law and the increase in employee contribution rates.  The successful Fields decision only challenged the change in the COLA formulation, as the plaintiffs in that case were already retired.  There is a shadow case against PSPRS, Parker v. PSPRS, that is challenging PSPRS on the same grounds as Hall.  The decision in the Hall case will settle both cases, so it has great relevance to any PSPRS member who was active when SB 1609 went into effect.

Unfortunately, the case still remains in the courts and the latest information shows it is under appeal.  This case will have to be settled by the Arizona Supreme Court, so we are still stuck in a holding pattern.  My amateur interpretation and prediction from an analysis of the Fields decision is that the plaintiffs will win on the question of COLA's but lose on the question of employee contribution increases.  The COLA question is a slam dunk for the plaintiffs and was already addressed in Fields.  COLA's were deemed a pension benefit and could not be changed per the Pension Protection Clause of the Arizona Constitution.  The question of employee contribution rates will depend on how the Arizona Supreme Court interprets the Contracts Clause in the state and federal Constitutions.  The Fields decision did not consider the Contracts Clause, but a reading of the decision shows that the question of employee contribution rates has no clear precedence and may not be covered under the Pension Protection Clause.  We will all have to wait and see how the justices rule.

The second issue I was hoping the PSPRS presentation would deal with was simpler: what a victory by the Hall plaintiffs would cost PSPRS.  According to PSPRS' esitmates, a plaintiff victory would cost PSPRS $931 million and drop PSPRS' aggregate funding ratio 4% and raise its aggregate contribution rate 6%.  He did not break down what would happen if the plaintiffs only won on just one of their questions, so this appears to be the cost of a total victory by the plaintiffs.  Remember that if the plaintiffs succeed on the question of employee contribution rates, anyone active at the time SB 1609 went into effect will be owed a refund of all contributions they paid in excess of 7.65%.  For the current fiscal year alone, that would 3.4% of pensionable income.  This would be a significant refund due of $2,040 for someone who had $60,000 in pensionable income in the current fiscal year.

I was more interested in what the Task Force had to say.  This portion was conducted by members of the Task Force, including former Tucson Chief Financial Officer and Deputy City Manager Kelly Gottschalk, who has since been hired to run the Dallas Police and Fire Pension System.  To say that their presentation, and particularly their recommendations to cities and towns dealing with pension costs, was a disappointment would be a huge understatement.

The Task Force was set up in June 2014 and made up of 15 members, mostly high-ranking municipal finance and administrative officials from throughout Arizona.  Last summer and fall, they had several meetings where they received presentations from various stakeholder groups and others with pension expertise.  There is a wealth of information on the Task Force website, and I was encouraged that finally something worthwhile was being done regarding PSPRS.  I thought that those municipal officials dealing with the harsh consequences of PSPRS' financial woes would finally have a chance to come together, brainstorm, and come up with some great reform ideas to present to the Arizona Legislature.  Boy, was I wrong.

Following are the Task Force's seven recommended practices for employers:
  1. Budget contributions for DROP members
  2. Prepay your budget contributions
  3. Do not defer the Fields case
  4. Review local board practices
  5. Prepare a comprehensive study
  6. Pay off unfunded liability (debt) earlier
  7. Create a pension funding policy
If we eliminate the three practices (numbers 4, 5, and 7) that are essentially administrative tasks, the other four come down to telling employers to pay more.  Of all the recommended practices, the first is the most ridiculous of all.  Recommended practice number 1 tells employers to budget for and continue to pay contributions for members who have entered the Deferred Retirement Option Plan (DROP).  However, the DROP was supposed to be a "win-win" for employees and employers where experienced employees remained on the job but neither employees nor employers would have to pay pension contributions for up to five years while the employee was in the DROP.  The Task Force is now saying that employers should continue to pay pension contribution for employees once they enter the DROP, meaning the employer gets no financial benefit from the DROP.  The most logical recommendation would have been to advocate for the complete elimination of the DROP, a program that has been starving PSPRS of funding for 15 years and will continue to do so as long as it remains active.

Recommended practices numbers 2, 3, and 6 all advise employers to pay money they do not have.  I agree with recommendation number 3 because it sets a bad precedent in a state where employers have always paid their full, required contributions.  Not paying full, required contributions is one of the surest ways to put a city on the path to financial ruin.  However, no one is advising employers to defer the additional costs imposed by the Fields decision, but Phoenix, Tucson, and other cities chose to do so because their elected leaders feel like they have no other choice since they simply can not afford the higher contributions right now.  Prepay your budget contributions?  Pay off the unfunded liability earlier?  With what funds?  If the cities had the extra money to do what the Task Force recommends, they would already being doing it.

The Task Force's recommended practices amounts to belling the cat.  The Task Force had a chance to offer some bold proposals and recommend some necessary reforms to PSPRS.  They did neither and wasted a valuable opportunity to have their voice heard.  Instead, they provided a list of embarrassingly impractical recommendations.  The work of the Task Force will be ignored by anyone serious about reforming PSPRS.

Monday, April 20, 2015

Invested in it: Chief Investment Officer Ryan Parham, PSPRS' investment strategy, and investment returns through February 2015

The following table shows PSPRS' investment returns, gross of fees*, versus the Russell 3000 for February 2015, the eighth month of the current fiscal year, with the June 2014 returns included for comparison:

Report PSPRS PSPRS Russell 3000 Russell 3000
Date Month End Fiscal YTD Month End Fiscal YTD
6/30/2014 0.78% 13.82% 2.51% 25.22%

7/31/2014 -0.67% -0.67% -1.97% -1.97%
8/31/2014 1.73% 1.05% 4.20% 2.14%
9/30/2014 -1.53% -0.49% -2.08% 0.01%
10/31/2014 0.40% -0.09% 2.75% 2.76%
11/30/2014 0.92% 0.82% 2.42% 5.25%
12/31/2014 -0.18% 0.64% 0.00% 5.25%
1/31/2015 0.01% 0.65% -2.78% 2.32%
2/28/2015 1.91% 2.58% 5.79% 8.25%

There is usually about a two-month lag in PSPRS reporting its investment returns.  There is not much new to report here.  PSPRS still lags the Russell 3000 and will be hard-pressed to achieve it 7.85% expected rate of return (ERR) by June 30, 2015, especially when we consider that the Russell 3000 lost one percent in March 2015.

I suppose now is as good a time as any to take stock of PSPRS' new investment strategy, which moved away a domestic equity-heavy, stock-picking portfolio to a more diversified and balanced approach.  In the 2012 Annual Report Summary, Chief Investment Officer Ryan Parham wrote:
Recent stress tests of on our portfolio indicate that we will capture approximately 70% of a strong up-market but only approximately 40% of a strong down-market.  Preventing that see-saw of returns produces a superior long term compounded return.This has been a key feature of the endowment investment universe which has historically produced better returns than public pensions.
Is the new strategy working as Mr. Parham's stress tests predicted?  Yes and no.  For fiscal year (FY) 2014, PSPRS captured 54.80% of the Russell 3000.  This is not 70%, but we must remember that PSPRS was never 100% invested in US equities, so it is not fair to compare it 100% vis-a-vis the Russell 3000.  Mr. Parham wrote in the 2013 Annual Report Summary , "At times more than 70% of the total fund was invested in U.S. large cap stocks." The maximum appears to be at the end of FY 2000 when PSPRS was 77.61% invested in common stock of what looked to be all US companies.  With this in mind, the 54.80% captured may be considered successful. 

However, for the current fiscal year to date, PSPRS is only capturing 31.27% of the Russell 3000 and failing to work as predicted.  In the three months that had a negative return, two were less than 40% of the monthly loss of the Russell 3000.  The third month grossly exceed the loss threshold at 73.55%.  In the four months that had a positive return, the highest was only 41.19% of the monthly gain of the Russell 3000. Depending on whether you consider the month in which the Russell 3000 had a zero return a loss or gain, PSPRS could have succeeded or failed.

While it may be too early to tell about the long-term prospects of PSPRS' new strategy, it did not stop Mr. Parham from boasting about the new strategy in the 2014 Annual Report Summary:
The Trust’s portfolio returns for the fiscal year ending June 30, 2014 continue to come from many diversified sources (10 separate asset classes.) We expect that diversification to help us to capture most of strong positive markets and to protect us from the worst of devastating negative markets. This was demonstrated in 2014 where we captured almost 3/4 of the returns of stock heavy portfolios. But in Q3 2014, when stocks were hard hit we had only 1/3 of the losses of those portfolios.
So if we extrapolate from Mr. Parham's rosy assessment of FY 2014, the Russell just needs to average to 14.32% every year in order for PSPRS to reach its 7.85% ERR (54.80% of 14.32%) every year.  In order to reach 9%, the Russell 3000 needs to just average 16.42% each year.  No problem, right?  The current 10-year annual rate of return on the Russell 3000 is 8.80%.  It will be interesting to see what new excuses Mr. Parham makes in the 2015 Annual Report Summary when PSPRS cannot even achieve its ERR for the current fiscal year.

* Returns, gross of fees, are used because PSPRS usually does not report returns, net of fees paid to outside agencies, except on the final report of the fiscal year.  The past two years fees have reduced the final annual reported return by about one-half of a percent.