Some observations about the League of Arizona's Cities and Towns' Pension Task Force final report on PSPRS

If you have not had a chance to read the League of Arizona Cities and Towns' Pension Task Force ("the Task Force") report, "The Yardstick: A Tool to Evaluate Proposed Reforms of Arizona's Public Safety Personnel Retirement System (PSPRS)," I would highly recommend that you do.  PSPRS is likely to see some big changes in 2016, and I think that the Task Force report will likely be part of any proposed reforms to PSPRS.

I had already discussed the main points of the preliminary report here, in case you are interested, and I found most of their recommendations to be quite good.  However, the big problem with the preliminary report was that it did not propose any method for funding the huge unfunded liability already existing in PSPRS if and when a new pension tier is created.  Unfortunately, this final report still does not address this problem, though the final report makes it clear that it is not a plan but rather "an evaluation tool for the current system and for potential reform proposals . . "   Still, the final report is a fuller and more detailed version of what was available back in May 2015, and there are several new things to discuss that were not available then.

1. The Deferred Retirement Option Plan (DROP) is an unfunded benefit.

I was happy to see the Task Force call the DROP what it actually is--an unfunded benefit.  Under the heading "Benefit Increases" the final report says, "The creation of the Deferred Retirement Option Plan (DROP) was a cost to the system when it was first implemented."  The Task Force also wrote, "We see the DROP as a costly method to extend retirement and a significant cost to employers during that period; therefore, it is recommended that the Deferred Retirement Option Plan not be included in any future system design."

I find it very encouraging that the Task Force is calling the DROP what it is, not a win-win for employees and employers or cost-neutral or any other of the other ridiculous terms that were used to justify this awful program.  However,  I disagree with the Task Force on one important semantic point.  While the DROP is a benefit, it is not a retirement benefit since it does not affect an employee's retirement benefit.  Rather, it only allows an employee to continue to work with their current employer while collecting a deferred retirement benefit, which essentially amounts to a 50% or higher raise for up to five years.  The Arizona Legislature should have eliminated the DROP as part of SB 1609 in 2011 since it likely would have been constitutional, and the Legislature should consider eliminating it now since it should have no part in any future reform measures.

The Professional Fire Fighters of Arizona (PFFA) is still trying to prop up the fiction that the DROP is necessary and beneficial, only now under a different rationale.  Their brilliant proposal is to rename the DROP the Inflation Protection Program and hope no one notices that it is the same bad idea.  The DROP was an ill-conceived and selfish program that should have never existed in the first place.  Its demise is long overdue.

2. Pension increases are to maintain purchasing power.

We all know that the current method of calculating cost of living adjustments (COLA's) or permanent benefit increases (PBI's) does serious damage to PSPRS.  Despite the victory of the plaintiffs in the Fields case and the likely victory of the plaintiffs in the Hall case, the excess earnings PBI model has been wrong from the beginning.  It was never sustainable and like the DROP was an ill-conceived and selfish idea that looked to lock in permanent benefits for one group at the expense of others.  It placed all the upside with retirees and all the downside with active workers and taxpayers.  Retirees were even paid PBI's even as active workers were having their pay and benefits frozen or cut.

However, retirees could be learning a hard lesson that they will not remain unscathed.  By putting their faith in the PSPRS' Board of Trustees and managers to earn enough to continue funding PBI's, they have also left themselves at their mercy.  Chief Investment Officer Ryan Parham publicly stated in the Arizona Capitol Times last December:

PSPRS wants its retirees to enjoy increases, but we are incentivized to seek lower returns in the range of 9 percent to maximize earnings that can be applied to cover – and hopefully reduce – unfunded liabilities.

PSPRS appears to be deliberately ratcheting back its investment returns in order to not exceed the 9% threshold that would trigger PBI's.  PSPRS has even lowered its expected rate of return (ERR) from 7.85% to 7.50%.  This is the unfortunate flip side of the excess earnings formula.  The Task Force writes:

. . . the new tier should should include cost-of-living adjustments (COLA's) to maintain the purchasing power of a retiree's pension.  The financial impact of COLA's should be included in the normal cost, not isolated in a separate fund and funded from investment performance.

We can see that the Task Force gets it.  They do not want to rely on investment performance, and they want true COLA's that keep retirees whole throughout retirement, which should be the real goal of any COLA.  Furthermore, budgeting for the COLA's in the normal cost (a percentage charged to pay the future benefit for an active employee) allows the COLA to rise with inflation of active workers' wages.  Union locals generally do a good job for their members, so if they are vigilant, they can keep both their members and retirees even with inflation by getting their members regular wage increases.  This way everyone's interests align.

This compares to the PFFA's plan, which would take 4% of active workers' pay to fund retirees' PBI's.  This PBI would be the lower of 2% or the consumer price index (CPI).  Here we again see the almost innate selfishness of those proposing this plan.  Those close to retirement, who will have to pay little or none of the 4% contribution, are likely retiring with large DROP payments, and are aware of PSPRS' deliberate lowering of investment returns, will transfer the cost of PBI's on to another generation of fire and law enforcement personnel who will pay 4% of their lifetime earnings to get up to a 2% benefit in retirement.

3. Consolidating PSPRS and the Arizona State Retirement System (ASRS) could reap huge benefits.

I do not know how ASRS feels about this.  For all we know, ASRS may want nothing to do with PSPRS.  However, we do know that ASRS has a better track record than PSPRS.  This is probably somewhat due to better management, but I think it is mostly due to the different rules under which ASRS operates.  Among these are equal cost sharing, stricter benchmarks for PBI's, and pooled assets and liabilities, all which are ideas the Task Force wants to implement with any new pension tier.

However, there is no doubt that ASRS has had better investment results over the years, which has nothing to do with the rules under which each system must operate.  Here is a comparison of their annualized net returns as of June 30, 2015:

	One Year	Three Year	Five Year	Ten Year
PSPRS	3.68%	9.22%	8.69%	5.22%
ASRS	3.20%	11.40%	11.80%	6.90%
Difference	0.48%	-2.18%	-3.11%	-1.68%

As we can see, ASRS bested PSPRS in all but the one-year return.  Of course, this was more than compensated for when ASRS earned 18.6% last fiscal year versus 13.28% for PSPRS.  As of June 30, 2015, PSPRS had about $6.218 billion in assets, the additional 1.68% averaged over ten years would earn an additional $1.775 billion.  This alone seems reason enough to consolidate PSPRS and ASRS.

4.  Forcing employers to contribute to the "third leg" of the retirement stool is a bad idea.

The Task Force talks about the need for a supplemental retirement program for those PSPRS members who do not participate in Social Security:

Retirement is often described as a three-legged stool, with one leg as the public pension, the second leg as personal savings, and the third leg as Social Security. Not all members of PSPRS participate in Social Security, which creates different retirement realities for each member. Many cities in Arizona employ a sworn police force that participates in Social Security; however, the same cannot be said about sworn fire fighters, who are typically exempt from participation.

Mandatory participation in Social Security would be a challenging feat. If PSPRS were to mandate that all members participate in Social Security, it would require a 100% vote by the current membership. Although this route would be ideal by offering another leg of the stool to members, it would be challenging to achieve.

Fair enough, but both the International Association of Fire Fighters (IAFF) and the Fraternal Order of Police (FOP) oppose mandatory participation in Social Security by their members, at least for those not already participating.  If you follow the FOP link, you will notice that they also want to repeal the Windfall Elimination Program (WEP) and Government Pension Offset (GPO).  The IAFF also supports elimination of the WEP and GPO, if it does not require mandatory participation in Social Security.

At first glance, the GPO and WEP may seem unfair to those who have paid into Social Security for the minimum 40 quarters.  However, we have to look at Social Security's original and actual purpose, which is clearly revealed in its name.  Social Security may be sold as a retirement plan for all Americans, but it is really meant to provide people security, in particular, security that they will have some form of income when they are no longer able to work.  (For more information about WEP, see this post.)  Both the WEP and  GPO are designed to prevent disproportionately generous benefits being paid to those whose years of non-participation in Social Security made their lifetime income seem smaller than it actually was.  These policies are designed to preserve as much income as possible to lower lifetime earners.  This is not popular to those who believe that Social Security is a retirement program like PSPRS, but it allows Social Security to fulfill its stated purpose.

It is hypocritical to demand an exemption from Social Security yet demand the maximization of  one's own benefits, especially when it hurts those that may have made much less in lifetime income.  This brings us back to the Task Force's ideas about the "third leg" of the retirement stool:

. . . the Task Force developed the idea of creating a Social Security-like replacement program for those not eligible for Social Security. Essentially, the replacement program would function as a defined contribution plan where both the employer and employee contribute equally.

If public safety unions are openly opposed to participation in Social Security, why does the Task Force feel there a need for another "third leg" to be created?   The third leg already exists, and if a group opposes participation, that is there own choice to forgo that leg.  There is nearly universal participation by American workers, including most other government workers and the US military, in Social Security.  Furthermore, why should employers and taxpayers be committed to another long-term employee benefit when a program already exists that employers and taxpayers must pay into themselves?

This is not to say that Arizona's public safety unions and their members are necessarily opposed to participation in Social Security, regardless of what the national organizations might say.  I do not know how they feel about the issue, and I understand that it would be virtually impossible to force current PSPRS members into Social Security.  However, the national organizations speak for public safety members on what would be a matter of federal legislation, so their position is the one that carries the most weight.  At the very least, new hires should have the freedom to choose to participate in Social Security, or if the Task Force believes the "third leg" is so important, they should be advocating that  all new public safety employees be required to participate.

I would love to see employers provide matching contributions toward a defined contribution plan for PSPRS members.  However, it is short-sighted and financially risky for the Task Force to recommend that employers be forced to contribute to another retirement program.  Employers can choose to contribute voluntarily to a defined contribution plan, but only as a negotiated benefit that is subject to modification when labor contracts are renewed.

5. Does the Task Force really know what PSPRS' fundamental problem is?

While overall the Task Force's final report is very good, they seem to have a curious misunderstanding of the relationship between PSPRS and its 256 employers.  Their final report says:

The PSPRS Board of Trustees functions as the plan administrator responsible for fiduciary responsibilities, such as investment management, setting actuarial assumptions, and benefits administration. Additionally, unique to this system, is the fact that each plan has a local board.  The local board makes decisions regarding eligibility, such as accepting members into the plan and determining disability retirements.

In practical terms, it means each local entity is responsible for managing a public safety pension plan, or plans. For example, the City of Phoenix has to manage two pension plans: police and fire. Self-management has proven to be an issue. Other than the largest member employers in the system, most entities do not have the resources and professional staff to manage a pension system. As such, they rely on the PSPRS Board and administration to provide oversight and management of their plans.

Unfortunately, self-management and the PSPRS Board have not resulted in the type of active management needed to prevent unfunded liabilities. For example, only a handful of employers have completed a detailed study of how their actual performance has compared to the actuarial assumptions. To this point, the Task Force created “Employer Recommended Practices” to assist employers with evaluating and improving the financial condition of their plan. These are included in this report as Appendix A and we encourage all employers to implement these practices.

Finally, given the fact that the employee contribution is capped at 11.65% of salary, any differences between actuary assumptions and actual performance manifests in unfunded liability, which is the sole responsibility of the employer.

The Task Force, which was comprised almost exclusively of municipal officials like city managers and finance and human resources directors, should know better how this all works.  Do they not know that the laws that govern PSPRS are made at the state level but must be followed by all employers, regardless of the employer's financial situation?  Do they not understand that employers have no control over actuarial assumptions, so if PSPRS chooses to use outdated mortality tables or an overly optimistic ERR, employers will have to make up the difference?  Do they think employers are just supposed to keep sending more and more money to PSPRS, even though they have no control over the bad laws or bad actuarial assumptions coming out of Phoenix?

The Task Force, of all people, should know where the fundamental disconnect in PSPRS lies.  Being a state agency, PSPRS is governed by state law, but the financial liabilities are borne by employers.  With the exception of the Department of Public Safety, the state government has very few PSPRS-eligible employees to worry about, and the state has much deeper pockets than any other employer.  Yet even some large employers like Phoenix, Tucson, and the state's counties are struggling to pay their annual required contributions, which are so high because of unfunded liabilities.

This is because there is no governance of the system from the employers themselves.  State legislators are lobbied by public safety unions to increase benefits, the costs of which fall, not on the state, but on the local employers and taxpayers.  It is easy to give things away when you do not have to pay for them.  Contrast this with what happened with the Elected Officials' Retirement Plan (EORP).  Though very small in comparison to PSPRS, this plan is the worst funded of the three that PSPRS manages.  EORP is for the most part a state plan, covering elected officials and judges.  When it became obvious that it was unsustainable, the Arizona Legislature simply closed the defined benefit EORP pension to new members and placed new members into a defined contribution plan.  Of course, those legislators who voted to exclude new members did not vote themselves out of the defined benefit plan, only those that came after them.

The Task Force is made up of the very people who should have been telling the Legislature that programs like the DROP were wrong or that a 9% ERR was unrealistically high.  If they had, PSPRS might be in better shape it is in now.  Of course, the municipal officials are at the mercy of their own local elected officials.  Look at what the Tempe City Council did when it allowed its firefighters to spike their pensions via a reconfigured sick leave sellback program.  The Tempe Fire Department is only 48.6% funded, and this will drive it further into deficit.  I would like to know what Task Force member Marge Zylla, a Tempe city official, thinks about what the Tempe City Council did.

These are just a few observations about the Pension Task Force's final report.  Hopefully soon we will take a closer look at the Arizona Auditor General's performance audit of PSPRS.