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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...

Thursday, August 17, 2017

How the House Ad Hoc Committee on PSPRS can begin fixing PSPRS (UPDATED)

***I have updated this post to correct an error about how contributions will be determined for Tier 3 members.  I have used strikethroughs for incorrect parts and italicized the corrected passages.  I apologize for these errors.***

In the last post, I made the suggestion to the House Ad Hoc Committee on PSPRS (“the Committee”) that they use their influence to press for the removal of PSPRS Administrator Jared Smout.  While this would be an overdue and important change, long-term it will have minimal effect on PSPRS, and long-term fixes are what the Committee is trying to find.

In Craig Harris’ article, “Arizona mayors call on Ducey to push overhaul of financially fragile public-safety pension system,” from the July 19, 2017 Arizona Republic, two reform ideas mentioned by State Senator Noel Campbell, Bisbee Mayor David Smith, and Prescott Mayor Harry Oberg were “the abolition of the PSPRS board and management, and . . . placing the fund's operation under the state treasurer,” and “ask voters to amend the state Constitution, which now dictates that a pension benefit given to a public employee cannot subsequently be taken away.”

The first idea could be accomplished more simply by changing the makeup of the Board of Trustees so that it was more representative of employers and taxpayers.  As far as I know, the Arizona legislature can staff the Board in any way it sees fit.  It is up to them to decide if employee representatives need to be voting members of the Board or what value and expertise firefighters and law enforcement officers contribute in the fields of actuarial science, finance, and investing.  PSPRS has four active members, two fire and two law enforcement, on its nine-person Board.  If this is excessive, they can change it.  There is no need to turn over the management of PSPRS to the Treasurer, just create a Board that knows what it is doing, and have these individuals hire a competent Administrator and other staff.

As to the second proposal, repealing or altering Article 29 of the Arizona Constitution, which prohibits the diminishment or impairment of pension benefits, would not affect the unfunded liabilities that already plague employers.  The excess contributions portion of the Hall case was decided in favor of the plaintiffs on the basis of case law (Yeazell) and did not rely on Article 29.  The contribution rate was deemed a binding contract between employees and employers that could not be changed unilaterally in favor of the employers.  Existing pension benefits also constitute a binding contract.  [Oddly, 2016’s PSPRS reform used Article 29 to accomplish the very thing it was meant to prevent.  Proposition 124 used a voter-approved amendment to Article 29 of the Arizona Constitution to eliminate the contractual and heretofore constitutionally protected permanent benefit increase (PBI) and replace it with a capped 2% cost of living allowance (COLA).]  Any change in benefits would still have to contend with case law, and most likely, the contract clauses of the Arizona and United States Constitutions, so repealing Article 29 is not the solution to the unfunded liabilities that already exist.

Currently, it seems virtually impossible to decrease any existing pension benefit, except through constitutional amendment (assuming Proposition 124 was constitutional) or the bankruptcy of an employer.  Any changes to PSPRS have to be prospective, affecting only those yet to be hired, administrative, or in line with existing pension benefits.  If the House Ad Hoc Committee on PSPRS wants to make some administrative, here are some suggestions:
Amend Article 29 of the Arizona Constitution to mandate equal contributions toward normal costs "the normal costs and the actuarially determined amount required to amortize the total unfunded accrued liability within the public safety pool" from employers and employees in any state pension that already has this requirement and for all future hires.  This is one of the most important changes that state legislators could make.  This would make cost sharing of normal costs all costs permanent and immutable.  The long game played by the state public safety union has always been to continually push for new or enhanced benefits like the PBI and DROP because the unions knew they were protected from any financial consequences by a fixed employee contribution rate.  This meant that no matter how costly the benefit became, it would never affect employees.  The cost would be borne by employers and taxpayers.  Splitting normal all costs would force any financial costs to fall equally on employers and employees and eliminate the perverse incentive state public safety unions have to push for unfunded enhancements of their pension benefits.  If the unions want to convince Arizona’s House and Senate to create a new or enhanced benefit, they will have to pay their fair share for it.

This amendment should not be controversial.  The state public safety unions already agreed to this condition for Tier 3 PSPRS members, and the Arizona State Retirement System (ASRS) and Corrections Officer Retirement Plan (CORP) already split normal all costs.  The Elected Officials’ Retirement (EORP) no longer has a defined benefit plan for new members.  Because of the Hall decision, nothing can be done about those PSPRS, EORP, and CORP members grandfathered into their respective systems with a fixed employee contribution rate.  This amendment would be simple to write and understand, and hopefully, the state’s voters would overwhelmingly approve.

Allow another state government entity to choose PSPRS’ actuaries, accountants, and outside investment consultants.  This goes hand-in-hand with the previous idea.  A neutral, objective party must give all stakeholders a realistic assessment of PSPRS’ financial condition.  As was seen with accounting firms and bond rating agencies, problems can arise when the organization being scrutinized is the one paying the company scrutinizing it.  I suspect it is only a matter of time before some major actuarial firm is sued for malpractice over a public pension that fails.

The Treasurer or Auditor General should set the engagement standards, choose, contract with, and pay (out of PSPRS' budget) the actuaries, accountants, and outside investment consultants.  The Treasurer or Auditor General should also receive the actuarial reports and financial statements before PSPRS does so that any problems identified cannot be covered up by PSPRS’ staff or Board of Trustees.  In Mr. Harris’ article, PSPRS Board of Trustees Chairman Brian Tobin boasts, “. . . that he has supported since 2011 legislation that would reform cost-of-living adjustments for retirees and have employees make higher contributions for their pensions.”  That’s the kind of bold, determined spirit you get from someone who will get nearly $1 million dollars his first year of retirement.  The funny thing is that page 8 of the Arizona League of Cities and Towns’ Pension Task Force Report says this:
. . . prior to FY 2015-16, the cost of the PBI was not included in the employer contribution rate.  Excluding the PBI from the calculation effectively underestimated the normal cost of the pension plan, causing it to manifest itself in the unfunded liability.  This issue  was  identified  by  PSPRS  actuaries several  years  ago,  but  the  PSPRS  Board  did  not  take  action to address it.
Keep in mind that Brian Tobin became Chairman of the PSPRS Board of Trustees sometime during fiscal year 2010.  He knew the PBI was a problem, yet in his official capacity as the Chairman, he did not require PSPRS to account for it in the normal cost, despite being informed of this problem by PSPRS’ own actuary.  This alone would argue for Mr. Tobin’s removal from the Board, and it is further evidence of Jared Smout’s unfitness to be PSPRS’ administrator.  What a duo we have leading PSPRS.

If the Arizona Treasurer or Auditor General had received a report from an actuary saying that PSPRS had, for years, not been accounting for a major driver of PSPRS’ underfunding, I think the problem would have been addressed much sooner and those responsible for this “oversight” would no longer be working at PSPRS.  As we see in this case, even when we have an ethical actuary raising a red flag, we still cannot trust PSPRS to take the proper action to address it.  With normal costs now split evenly between employees and employers, there will be even more incentive to lowball normal costs, as any normal costs not properly accounted in the present will appear later as unfunded liabilities.  Unfunded liabilities will be the sole responsibility of employers and taxpayers.  For the sake of Tier 3 members and employers who will have to foot the bill for any of PSRPS' chicanery, this is why someone other than PSPRS must choose its actuary, accountants, and investment consultants.

Subject PSPRS to a more comprehensive analysis of its investments, fees, and how PSPRS' investment strategy compares with those of other funds.  This report, of course, would have to be produced by an outside entity hired by another state agency.  The Panglossian world of the PSPRS office is one where whether PSPRS makes money, loses money, or underperforms, it is always doing great.  PSPRS is always in some top segment of some subset of funds, but it underperforms its own Cancer Insurance Plan and ASRS.  What of all its investments in private equity and real estate?  These are notoriously hard to value.  What methodology is used to value these?  Furthermore, as of last fiscal year, PSPRS had, by my count, 74 private equity investments, but only 11 of these investments accounted for 83% of its gain in its private equity portfolio.  It is great that this asset class is earning good (paper) returns, but how is this different than picking individual stocks.  When your portfolio gets big enough, when do your picks become luck rather than any display of skill?  What would PSPRS have done if it had used other strategies, paid lower fees, or simply invested in the S&P 500 since 2000?  We already know we cannot trust Mr. Tobin or Mr. Smout to accurately account for normal all costs.  Why would we trust them to provide accurate investment figures or assessments?

The Arizona Legislature must get other political subdivisions involved in any penson benefit legislation they pass in the future.   The legislature and state public safety unions have always negotiated pension benefits over the heads of the cities, towns, counties, fire districts, and tribal nations who have to pay for them.  These groups must get a seat at the table whenever changes in benefits are considered.  Outside of the Department of Public Safety, the state has no large employee group in PSPRS, and the state has much deeper pockets than other political subdivisions.  Unfortunately, I am not sure of a way that this can be mandated
I personally think that the Legislature should not determine PSPRS benefits.  They farmed out negotiations for 2016’s pension reform to Reason Foundation, a private, public policy research group, so I don’t know why they don’t allow the Arizona League of Cities and Towns or some other group acceptable to the political subdivisions to negotiate with the state public safety unions.  I suppose the League could also use Reason Foundation as a consultant to help them out.  The political subdivisions and the unions are the two parties most affected by pension legislation, and they should be able to come to some agreement about what is best for both of them.  This is routine business at the local level w here these groups negotiate over wages and benefits.  The Legislature has to realize by now that the status quo cannot continue, and political subdivisions must have some part in determining pension benefits.  This is what Mayors Oberg and Smith should really be advocating for if they want to stop the pension debt monster from coming back to ravage their cities in 25 or 30 years.
The bottom line is that too many elements inside and outside of PSPRS have been allowed to run unchecked for too many years.  While it appears that nothing can be done about pension benefits already promised, these are some easy, non-litigatable steps to rein in those who cannot control their own myopia, greed, selfishness, and stupidity.

Saturday, August 12, 2017

Out with Smout: It's time to get rid of PSPRS Administrator Jared Smout

I hope most PSPRS members have read this article, "Pension executive defends six-figure retirement payouts for police, firefighters," by Craig Harris in the August 10, 2017 Arizona Republic.  If not, please take the time to read it because it goes a long way in showing why PSPRS is in the mess it is today.

The pension executive to whom the article is referring is PSPRS Administrator Jared Smout. What he was shamelessly defending before the Arizona House Ad Hoc Committee on PSPRS was the Deferred Retirement Option Plan (DROP).  Keep in mind that Mr. Smout is the person in charge of PSPRS, not a spokesperson or a self-interested individual like PSPRS Board of Trustees Chairman Brian Tobin, a man who will get nearly $1 million in pension and DROP payments during his first year of retirement.  The one individual from whom we should expect an honest appraisal is the  PSPRS Adminstrator.

I have had the misfortune of hearing Mr. Smout speak publicly.  If you did not believe that someone could be both arrogant and banal, go see Mr. Smout speak.  If you ever saw former Federal Reserve Chairman Alan Greenspan speak before Congress, you will get a sense of Mr. Smout's style of delivery.  Of course, this is the only similarity between those men--Alan Greenspan has a much more varied and accomplished background than PSPRS lifer Jared Smout, but perhaps Mr. Smout thinks that if he talks like Mr. Greenspan, his words will be accorded the same gravity and credibility.  Why else would he say that "there was a perception problem with the Deferred Retirement Option Plan — or DROP — and that it was a "myth" that the program has cost the pension trust a 'huge' amount of money" unless he thought the Committee would just believe him out of hand because he speaks his  financial jargon in such a condescending tone.

Mr. Smout has to be ignorant, incompetent, and/or deceitful to make a statement like that in front of a congressional committee.  The DROP is indefensible.  It was a blatant money grab from the pension perpetrated during a brief period when PSPRS was overfunded.  Among problems with the DROP are:
  1. For many years it paid a guaranteed interest rate of up to 9%, even when PSPRS was losing money. 
  2. It robs PSPRS of funding.  A pension relies on a constant stream of funding to stay solvent.  These funds must compound over time, and if the actuarials are correct, a BIG if, the pension can stay solvent in perpetuity.  The DROP interrupts this funding stream.  If five members all DROP for the full five years at 25 years of service , the pension will lose 25 years of funding from employees who are likely to be at their highest pay.  That's an entire career of payments into the pension that will never be paid.
  3. It slows the replacement of higher paid Tier 1 employees with Tier 3 employees.
In case Mr. Smout truly is ignorant, let's explain it to him as simply as possible: An employee cannot be active and retired at the same time.  This is common sense.  You can either have a longer career and get a higher pension for fewer years or you can have a shorter career and have a smaller pension for more years.  This is Pensions 101.  This is why no other retirement systems allow the DROP, with the exception of other well-managed public safety pensions like the Dallas Police and Fire Pension Plan.  PSPRS' own policy states that "at ANY time following retirement, if you are re-employed in the same, or substantially similar position by the employer from which you retired, your retirement benefits will be suspended."  This policy prevents employers from hiring back their own public safety retirees, at a lower cost as they would no longer have to pay pension contributions for these employees, in place of new employees for whom contributions would have to be paid.  The obvious reason for this policy is to prevent employers from starving PSPRS of the consistent funding stream it needs to stay financially viable.  This PSPRS policy prevents an employer from doing the very thing the DROP permits.  Yet, Mr. Smout defends the DROP and says that "his organization concluded it was largely cost-neutral."

I know nothing of Arizona State Senator Noel Campbell's background, but he seems to understand the DROP better than Mr. Smout.  Mr. Harris writes:
Campbell also said he didn't believe Smout's assertion about DROP's cost. The lawmaker said his examination of PSPRS records suggested DROP is "a very expensive drain on the fund," and he believes the benefit should be terminated for all current employees.
Campbell also characterized DROP's guaranteed rate of return as too generous, noting it would be nearly impossible to find in the private sector. He said DROP prevents local governments from hiring new, less costly employees to replace "retired" officers in DROP for five years. Unlike many officers in DROP, those new employees also would be making individual contributions to the retirement system.
Senator Campbell does not believe Mr. Smout, and neither should anyone else.  If there are still any defenders of the DROP, PSPRS, or Mr. Smout, here is more from Mr. Harris' article:
. . . the Arizona State Retirement System, which is in better financial health, ended DROP because of major cost concerns.
Paul Matson, chief executive of the ASRS since 2003, said in an earlier interview that the ASRS, the much larger pension system, never implemented DROP because it would have significantly increased trust payments for members and their government employers. 
Matson had lawmakers revoke DROP for ASRS members in 2006.
"We didn't implement it because we didn't want contribution rates to increase," Matson said. 
The ASRS trust is in better financial health than the PSPRS. The pension system for teachers and state and local government employees has a funded ratio of 76 percent, meaning it has about three-fourths of the money it needs to pay all current and future liabilities.
ASRS is 76% funded.  PSPRS is about 47% funded.  ASRS has a contribution rate of 11.50% apiece for employers and employees.  PSPRS has an aggregate employer contribution rate of 52%, with much higher employer contribution rates for some employers.   ASRS has needed only limited adjustments, while PSPRS is continually in need of major reforms.  Paul Matson, who has worked for ASRS since 1995 and been its Executive Director since 2003, says that the DROP is a bad policy that would have caused contribution rates to increase for ASRS employees and employers, and he had it revoked in 2006 well before the financial downturn of 2008-09.  Mr. Smout says the DROP is just fine and dandy.  Should you believe Mr. Matson or Mr. Smout about the DROP? 

One man works proactively to reverse a harmful policy to the benefit of all stakeholders.  Another man continues to defend an obviously deleterious policy that benefits only one group of employees at the expense of all other stakeholders.  Sadly, what stands out most in this article is the utter cravenness of Mr. Smout.  His statement before the committee was his chance to do the right thing and, at the very least, admit that the DROP was a costly error on the part of Arizona's legislature.  As an administrator, he was not responsible for the statute that created the DROP, but
I would say he has a responsibility to speak the truth when a state law is enacted that negatively affects the system he administers.  Mr. Matson did.  Why wouldn't Mr. Smout do the same?

I suppose Mr. Smout is lucky to still be employed by PSPRS, much less working as its Administrator.  When former Administrator James Hacking was caught giving illegal raises to some PSPRS employees, Mr. Smout, the Deputy Administrator at the time, turned out to be the person who authorized payroll to process the illegal raises.  Mr. Hacking agreed to resign after negotiations with the Board of Trustees, but Mr. Smout remained with PSPRS and was eventually tapped to lead it.  It would seem that the Deputy Administrator should have known that what he was authorizing was illegal and should have taken a stand against it.  However, he did not and, in the end, this act actually helped to move Mr. Smout up the PSPRS ladder.  I guess Million Dollar Man Brian Tobin and the other Trustees saw something in Mr. Smout's weak-willed behavior during that episode that made them think he was the best person to run PSPRS for them. 

If the House Ad Hoc Committee on PSPRS wants to begin the process of administrative reform at PSPRS, they should press for the removal of Jared Smout as PSPRS Administrator.  A man with neither the will nor the backbone to do what is right should not have the future of so many hard-working people in his hand.