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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...

Saturday, December 1, 2018

Just in time for Christmas, here's something for everyone: the DROP, service purchases, COLA's, and investment returns through August 2018 (CORRECTED)

PSPRS had its November 2018 Board of Trustees meeting this week, and there are several things in the meeting materials that might interest PSPRS members:

Rollbacks of changes to the Deferred Retirement Option Program (DROP) and service buybacks

1. The changes to the DROP program affects both the interest paid on DROP contributions and member contributions to the DROP.

The change in member contributions to the DROP  This affects what used to be called Tier 1b members, members who were PSPRS members before January 1, 2012 but did not have 20 years in the system.  Tier 1a members were those with 20 years in the system before January 1, 2012.  Tier 2 and Tier 3 members are not eligible for the DROP.  Currently, if you are a Tier 1b member and are or will be in the DROP, you must continue to pay the 7.65% member contribution to PSPRS.  These accumulated contributions are repaid to you when you permanently leave employment, along with 2% interest.  This program, the Contributory DROP, will end in January 2019.

This means that if you are currently in the DROP you will be entitled to a refund of your accumulated contributions plus interest, minus taxes, as these contributions were pre-tax and did not have income tax withheld when they were first taken.  It appears that the interest rate will be PSPRS' assumed rate of return (ARR) at the time the contributions were taken.  This rate has gradually decreased since fiscal year (FY) 2012 from 8% down to the current ARR of 7.3% for FY 2019.  It also appears that the refunded contributions and interest will be handled like the refunded contributions from the Hall/Parker decisions with taxes taken out them at 22-25%.  Interest payments would not have taxes withheld and would be reported on a 1099 at the end of the tax year.  If this interest payment was paid as post-Hall/Parker, it would come in the form of a check or direct deposit from your employer.

If you were in the Contributory DROP and have retired, you should have received your accumulated contributions and 2% interest, but you will still be due some type of interest payment with the same aforementioned tax situation.  If you have yet to DROP, you will simply see an increase in your weekly pay as you will no longer pay the 7.65% member contribution once you enter the DROP.

Change in DROP interest rates  Currently, the DROP pays or would pay a Tier 1B member an interest rate on the accrued monthly retirement benefits in his DROP account that is equal to PSPRS' 7-year average return or the ARR, whichever is lower.  This 7-year average return is currently 6.60%, but since FY 2012 it has been as low as 3.10%. Prior to the implementation of SB 1609, the interest paid on a member's DROP contributions was the ARR, which has ranged between 7.3% and 8.0% since FY 2011.

This means that anyone who is currently in or has participated in the Contributory DROP will get some increase in their final DROP payment as the ARR has always been higher than the 7-year average return.  Those who DROP in the future will see their DROP contributions grow at whatever the ARR is at that time.

With this change in the DROP interest rate increasing his final DROP payment, PSPRS Board of Trustees Chairman Brian Tobin may literally be a Million Dollar Man during his first year of retirement.  It seems like a conflict of interest that he did not recuse himself from the final vote on a proposal that would give him such an immediate personal financial benefit, but it appears that his vote was necessary to pass the proposal as they barely had a quorum at the previous Board of Trustees meeting.  I have been informed that Mr. Tobin is in the non-contributory DROP, which means that Mr. Tobin's vote had no effect on his personal DROP benefit.  I apologize to Mr. Tobin and readers for this error.

2. Change in discount rate for service purchases

The DROP was always a late-career money grab for senior PSPRS members, so these changes will unfortunately just add to the unfunded cost of this benefit for Tier 1 members.  However, the change to service purchases will, at least partially, reverse an unfair change to PSPRS.  For more detail, about the original change, you can read about it in this post from July 2016, but the gist is that PSPRS will once again use PSPRS' ARR as the discount rate to calculate service purchases.

This had changed to a rate based on the 10-year US Treasury (T-bill) bill rate plus 2% or the ARR, whichever is lower.  As we know, interest rates had been low for a quite a while, and accordingly, so has the 10-year T-bill rate, making it the lower of the two discount rate.  This method has benefited  PSPRS since it forces members to value their time at a lower rate than PSPRS expects to earn on its own investments, forcing members to pay more upfront to buy their service time.  This turns members into another profit center for PSPRS.  So members were either being forced to donate money to PSPRS in order to purchase their service time or forgo the purchase completely, as this change made service purchases much more expensive and out of reach for many members.

Reverting to the use of the ARR will mean members' upfront payments will be expected to earn the same rate as the rest of PSPRS investments, making the upfront payment lower and more manageable.  Members will no longer be treated as a revenue source by PSPRS.  Those who purchased service at the lower rate can expect to get refunds when service purchases are recalculated at the higher ARR (7.3% or 7.4%, depending on when the time was purchased).  Tier 1 and Tier 2 members who have yet to purchase service time will have the cost calculated using the ARR in effect at the time of purchase.

As for Tier 3 members, the lower of the 10-year Treasury bill rate plus 2% or the ARR is still in effect.  As we can see, this policy is an injustice, not for merely constitutional reasons, but because it is out-and-out theft from PSPRS members.  Tier 3 members, many of whom I speculate will want to buy time from their military service in Iraq and Afghanistan, deserve to be treated the same as Tier 1 and Tier 2 members and not be ripped off by PSPRS.  Tier 3 members were sold out by the Professional Fire Fighters of Arizona (PFFA), PFFA president Bryan Jeffries, and the other state law enforcement unions and their personnel when the third tier was created to protect the disproportionately generous benefits of Tier 1 members.  Tier 3 members should judge these state public safety unions and their senior leadership by how hard they work to correct this injustice.

The relevant portion of the meeting materials can be found on PDF page 261-265.

PSPRS tries to explain why it pays so much in investment fees

PSPRS' management and Board of Trustees got their feelings hurt by the Pew Center for the States (Pew), which reported that PSPRS paid, far and away, the highest external management fees of the 44 funds that report returns, net of fees, for FY 2016, and they make an attempt to explain why they received this dubious honor.  Readers can see PSPRS' explanation on PDF pages 189-191.

In the end, PSPRS' explanation is meaningless without any context from the other 43 funds Pew included in its study.   Did all the other 43 funds profiled under-report to Pew the fees they paid?  Did Pew over-report PSPRS' fees while accurately reporting every other fund's?  Is PSPRS saying the researchers at Pew, who do these types of analyses all the time, don't understand the fee structure, or are they just biased against PSPRS?

I checked back at Pew's website, and I saw no corrections or clarifications to the report.  What still appears is that PSPRS paid the highest external management fees, which were more than double the next highest fund, and they had the third worst returns.

PSPRS FY 2018 Actuarial Report

The PSPRS FY 2018 Actuarial Report was not included in the meeting materials, just a set of PowerPoint slides.  The important information is that PSPRS' aggregate funded ratio improved slightly from 45.3% at the close of FY 2017 to 45.8% at the close of FY 2018.  The aggregate employer contribution rate increased slightly from 51.93% to 52.31% from FY 2017 to FY 2018.  Tier 3 members are accounted for separately from Tier 1 and Tier 2 members, and all Tier 3 employers, are funded between 75% and 125%.  More importantly for Tier 3 members, who must split contributions 50/50 with employers, the range of employee contribution rates is 9.50% to 10.88%, depending on the employer.  It is about an even split between rates going up and rates going down.  These Tier 3 contribution rates can be found on PDF page 311.  The new rates will go into effect in FY 2020 starting July 1, 2019.  Tier 1 and Tier 2 members' contribution rates are fixed at 7.65% and 11.65%, respectively.

PSPRS expects to have its final consolidated annual report and actuarial reports complete by the end of the year.  Members can find out the status of their own employers' funded ratios and contribution rates when those reports drop sometime this month.

PSPRS investment returns through August 2018

The following table shows PSPRS' investment returns, gross of fees*, versus the Russell 3000 through August 2018, the second month of fiscal year (FY) 2019, with the past five FY end 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%
6/30/2018 -0.66% 7.76% 0.66% 14.78%

7/31/2018 1.03% 1.03% 3.32% 3.32%
8/31/2018 0.94% 1.98% 3.51% 6.95%

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

Once again, there is not much to comment on so early in the fiscal year, especially with the volatile months of October and November still to be reported.  It will be interesting to see how PSPRS did those two months.  The Russell 3000 had a large loss in October 2018 but managed to earn 2.0% in November 2018.  PSPRS did not report results for September 2018 in these materials, even though they would normally be reported in the November meeting materials.  PSPRS did not have a Board of Trustees meeting in October 2018.

Inflation and COLA's

2018 has not come to a close, but it seems likely that inflation in the Phoenix-Mesa area will be over 2% for the calendar year.  The 2018 first half inflation was 3.9%, meaning inflation in the second half of 2018 would have to be zero or negative for it to be be below 2%.  This means retirees should  expect a 2% COLA in their benefits starting July 1, 2019.

Thank you for reading.  I hope everyone has a safe and happy holiday season.

* 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.  Returns, net of fees, were 13.28% in FY 2014, 3.68% in FY 2015, 0.63% in FY 2016, 11.85% in FY 2017, and 7.07% in FY 2018.


  1. I would expect you to do at least a tiny bit of research for your stories but I guess that is to much to ask.
    1. Tobin is non- contributory drop so changing tier 1b drop has no impact on him.
    2. If you actually listened to the meeting you would of heard that the board voted to keep tier 3 rates the same as they are this year for next year.

    1. Thank you for the correction. I have changed the post to reflect this information regarding Mr. Tobin. As to your second point, meeting minutes are the only official record of any Board of Trustees meeting. That is why the Board must vote to approve them in the following month's meeting. Without the official meeting minutes, how am I to know that you are providing me with accurate information or that you heard correctly what was said in the meeting? I present what is in the meeting materials as it is the most up-to-date information available and what is likely to interest readers.

  2. They pay the highest fees so as to enrich themselves and friends. Politics 101. Until enough people stop drinking the koolaid and speak up they will forever do it. But be careful actives, if you do speak up you will be criticized and punished.

  3. My concern has always been that if, or when, inflation starts to increase rapidly PSPRS retirees wil fall further and further behind when the maximum COLA is set at 2%. All one has to do is look back at the 1980s to see inflation at 15-18% to understand how devastating that will be to those of us locked into a low COLA rate. Last year I asked Jared Smout, PSPRS director, what would occur if inflation increased. His reply was that “he was sure the Arizona legislature would step in and help.” Yeah, right!

    1. I agree. It would only take a few years of 5-10% inflation to drop the value of a retiree's benefit 20-30%. Nevermind what early 1980's inflation would do. This would be devastating to anyone, but particularly to someone who just recently retired.

      Inflation is the easiest tool for PSPRS to use to become fully funded. Inflation is good for debtors like PSPRS. If inflation takes off, PSPRS can take advantage of increasing rates of return, particularly on risk-free investments like Treasury bills, while the value of retirees' benefits shrink every year. Voila, PSPRS becomes fully funded on the backs of retirees.

      As for future inflation protection, remember that COLA's are now funded through contributions from employees and employers. How willing will Tier 3 members, who in 10-12 years will be the majority of active PSPRS members, be to see their paychecks reduced in order to help the Tier 1 members who shafted them with legislative changes supported by today's cabal of union leaders? Most likely they will take any benefits from higher inflation for themselves,via wage increases and lowered contributions rares, as they should. The current public safety union leadership wanted these changes to protect their own benefits, and they should be forced to live with the consequences of those changes. Thanks for your comment.


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