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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, March 1, 2018

Inflation, COLA's, the future of PSPRS, and investment returns through December 2017

The following table shows PSPRS' investment returns, gross of fees*, versus the Russell 3000 through December 2017, which is the midpoint of the current fiscal year (FY), with the FY end 2014, 2015, 2016, and 2017 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%
6/30/2015 -0.73% 4.21% -1.67% 7.29%
6/30/2016 -0.32% 1.06% 0.21% 2.14%
6/30/2017 0.22% 12.48% 0.90% 18.51%

7/31/2017 0.83% 0.83% 1.89% 1.89%
8/31/2017 1.06% 1.91% 0.19% 2.08%
9/30/2017 0.80% 2.72% 2.44% 4.57%
10/31/2017 0.64% 3.38% 2.18% 6.85%
11/30/2017 1.28% 4.70% 3.04% 10.10%
12/31/2017 0.66% 5.39% 1.00% 11.20%

There is usually about a two-month lag in PSPRS reporting its investment returns.

Through the first half of the current fiscal year (FY), PSPRS is returning about 48% of the Russell 3000.  PSPRS has pretty consistently been capturing 50-60% of the Russell 3000 as this table shows:

Time Period Captured
FY 2014 54.80%
FY 2015 57.75%
FY 2016 49.53%
FY 2017 67.42%
Calendar Year 2017 53.90%
3-year Annualized 67.00%
5-year Annualized 53.72%
10-year Annualized 55.23%

The exceptions are FY 2017 and the 3-year annualized returns, but the 50-60% range seems to hold for long and short periods and for periods of high and low returns.  The only data missing is a year of longer period(s) of negative return(s).  It will be interesting to see what the month of February 2018 does to these numbers as the Russell 3000 lost 3.69%.  This loss is lower than mid-February when the Russell 3000 was down as much as 8%, but we will see what PSPRS' alternative investments do to counteract the losses in equities.  Unfortunately we will not get to see these numbers until April.  The Arizona State Retirement System (ASRS) had a Board of Trustees meeting on February 23, 2018, and its meeting packet included returns up through February 12, 2018.  I do not know why PSPRS cannot provide more up-to-date numbers in its meeting packets.  Between January 29, 2018 and February 12, 2018, ASRS' FY 2018 return dropped approximately 3% from about 11% to about 8%.  These ASRS numbers come from a graph on PDF page 29 of the meeting packet.

Through the end of December 2017, ASRS looks to have had a FY return of approximately 8.50%, over 3% more than PSPRS through the same time period.  PSPRS' Cancer Insurance Plan (CIP) has returned 6.82%, net of fees, through December 2017, also beating PSPRS by about 2%, when we subtract a half percent in fees from PSPRS' returns.  If this 50-60% capture range remains consistent, the Russell 3000 would need annualized returns of 12.33% to 14.80% in order for PSPRS to achieve its assumed rate of return of 7.40%.

The meeting minutes from January 2018 show that the Board of Trustees unanimously approved the use of the calendar year Phoenix-Mesa CPI-U to determine the cost of living allowance (COLA) for retirees.  The first of the new COLA's will be paid in FY 2019.  More detail about this is in this post from earlier this month.  The relevant statutory language about COLA's is:
A retired member or a survivor of a retired member shall receive annually a cost-of-living adjustment in the base benefit based on the average annual percentage change in the metropolitan Phoenix-Mesa consumer price index published by the United States department of labor, bureau of labor statistics, with the immediately preceding year as the base year for making the determination ....
The gist of this is that retirees will be getting a 2.0% COLA starting July 2018.  The average inflation rate in the 2017 calendar year was 2.5%, 2.2% in the first half of 2017 and 2.7% in the second half.  Starting this year, inflation numbers will be provided every two months, instead of just twice a year, which means average inflation calculation will be based on six rates, not just two.  The first of these two-month rates will come out in about two weeks.  The meeting materials from January 2018 showed the average inflation rates for Phoenix-Mesa from 2004 to 2017.  For a PSPRS member who retired in 2003 with a $3,000 monthly benefit, this is the difference between actual average inflation and the new COLA benefit:

               Average               Actual                   New
Year       Inflation               Cost       COLA     Benefit
2004       1.8%                     $3,054   1.8%      $3,054
2005       2.9%                     $3,143   2.0%      $3,115
2006       3.0%                     $3,237   2.0%      $3,177
2007       3.4%                     $3,347   2.0%      $3,241
2008       3.5%                     $3,464   2.0%      $3,306
2009       -1.4%                    $3,416   0.0%      $3,306
2010       0.6%                     $3,436   0.6%      $3,326
2011       2.8%                     $3,532   2.0%      $3,392
2012       2.2%                     $3,610   2.0%      $3,460
2013       1.3%                     $3,657   1.3%      $3,505
2014       1.6%                     $3,715   1.6%      $3,561
2015       0.2%                     $3,723   0.2%      $3,568
2016       1.6%                     $3,782   1.6%      $3,625
2017       2.5%                     $3,877   2.0%      $3,698

Over the 14 years since the member's retirement, the monthly loss of purchasing power would have been $179 or $2,148 annually.  This retiree would only be able to purchase about 96% of what he could in 2003.  This is not insignificant, especially if one is living on a fixed income.  If we eliminate the one year of deflation in 2009 and replace it with 0% inflation, the monthly loss goes up $55 to $234 and the annual total to $2,811, leaving the retiree only able to buy 94.5% of what he could in 2003.  In the 14 years, we have seven years with inflation under 2%, including one year of deflation, and seven years of inflation over 2%.  Outside of deflation or perpetual 2% inflation, retirees will always end up losing purchasing power over time.

If we project out another six years for this hypothetical PSPRS retiree using the current 2.5% annual inflation for 2018 through 2023, after 20 years in retirement the retiree will have lost about 7.5% of the value of his retirement.  If inflation is 3% over that same six-year period, the loss will be 10%.  Your guess is as good as mine as to what extent the recent market volatility has been driven by fears of higher inflation, but the prospect of higher inflation is certainly concerning if you are already retired.

This is again a reminder to those still working to fund another source of retirement income and not rely solely on your PSPRS pension.  If inflation does take off, it only benefits debtors like PSPRS, which can pay retirees benefits that will decrease in value over time, while it takes advantage of the rising rates of less risky investments like US Treasury and high-grade corporate bonds.  As recently as 2000, anyone could invest in a six-month certificate of deposit (CD) earning 5% a year at a time when the US inflation rate was 3.4%.  With inflation at this level, a PSPRS benefit would lose value every year, and it is critical to have some other retirement savings that can benefit from risk-free instruments like CD's to maintain a lifestyle.

As for current retirees, what options do they have?  Unlike the ASRS Board of Trustees, where one of the seven seats is held by a retiree representative, they have no representation on the PSPRS Board of Trustees, where four of the nine seats are filled by active PSPRS members.  The cost of the new COLA system is also included in the annual contribution rate that is split 50/50 between employers and Tier 3 employees (those hired in FY 2018 or later).  These Tier 3 employees (whose COLA will be determined on a sliding scale, based on PSPRS' funded level) are already getting a less generous, more restrictive COLA than Tier 1 and 2 members.  Why would they push for higher COLA's for current retirees when this will eat into their wages, especially after the previous generation shafted them?  They are more likely to push for more non-PSPRS retirement enhancements like matching contributions to their deferred contribution accounts.  Tier 3 members will likely become the majority of active members within 10-12 years.

This situation was brought to us by the blue falcons in the leadership of the Professional Fire Fighters of Arizona (PFFA) and, to a lesser extent, the state law enforcement unions, who played Sancho Panza to the PFFA in this matter.  Not content with just selling out existing retirees and future public safety workers, they set the precedent of altering contractually-bound pension benefits via referendum through their support of Proposition 124.  This will come back to haunt all PSPRS members if there is another pension crisis in Arizona, especially when we have been "led" by people like PFFA President Bryan Jeffries who told the New York Times, public safety members "should volunteer to cut their own pension benefits" during a financial crisis.  However, the final deal he and others brokered with the Arizona Legislature did clarify that he didn't mean his generation of public safety members should sacrifice any benefits, just those that came before and after him.

* 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.  Returns, gross of fees, are used in the table for consistency.  The past two years fees have reduced the final annual reported return by about a half percent.  Returns, net of fees, were 13.28% in FY 2014, 3.68% in FY 2015, 0.63% in FY 2016, and 11.85% in FY 2017.