Why you should hate the Professional Fire Fighters of Arizona's (PFFA) PSPRS reform proposal, Part II

In the last post we talked about why the Professional Fire Fighters of Arizona (PFFA) PSPRS pension reform proposal was bad for active PSPRS members.  In this post, we will talk about why it is bad for retirees.  This is more complicated than talking about the implications for active workers for a couple reasons.

First, and most importantly if you are a retiree, COLA's are not an abstraction to you.  COLA's are a very real source of income that you may already be relying on, and you retired with an expectation of receiving this income.  A retiree has a lot more at stake in the here and now than someone who has 25 or 30 years left before he or she retires.  Second, it is necessary to have a basis of comparison in order to make an informed decision about the PFFA proposal.  Since no one can see into the future about what economic conditions, I have created a table for some comparison:

Fiscal Year End	PSPRS Rate of Return	PSPRS Funding Level	Excess Earnings COLA	PFFA 2% COLA Formula	SB 1609 COLA Formula
1998	22.23%	116.3%	$        81.95	$      40.98	$    81.95
1999	17.70%	120.3%	$        87.37	$      43.69	$    87.37
2000	12.31%	124.7%	$        93.24	$      46.62	$    93.24
2001	6.02%	126.9%	$        98.17	$      49.09	$          -
2002	-15.00%	113.0%	$      102.53	$      51.27	$          -
2003	6.70%	100.9%	$      111.90	$      55.95	$          -
2004	14.97%	92.4%	$      116.82	$      58.41	$  116.82
2005	9.11%	83.2%	$      121.76	$      60.88	$          -
2006	8.30%	77.6%	$      127.06	$      63.53	$          -
2007	17.06%	66.4%	$      134.34	$      67.17	$    83.96
2008	-7.27%	66.5%	$      138.66	$      69.33	$          -
2009	-17.72%	68.2%	$      146.74	$      73.37	$          -
2010	13.47%	65.8%	$      152.84	$      76.42	$    95.53
2011	17.37%	61.9%	$      159.13	$      79.57	$    79.57
2012*	-0.79%	58.6%	$      121.19	$      87.47	$          -
2013*	10.64%	57.1%	$        65.20	$      87.65	$          -
2014	13.20%	49.2%
Total			$   1,858.90	$ 1,011.38	$  638.43

The table shows a comparison of the different monthly COLA increases that have or would have been paid under the current excess earnings formula, the PFFA 2% formula, and the SB 1609 formula.  I went back to 1998 because that is as far as the reports go back on PSPRS' website.  However, it works out well because it covers a period several years before the first big financial crisis up until fiscal year (FY) 2013.  Please keep in mind that the COLA amounts are determined in the FY listed but paid in the next fiscal year.   I placed an asterisk (*) by FY's 2012 and 2013 because the excess earnings COLA amounts appear to be less than 4% of the average normal retirement amount, so this was not the maximum COLA allowed under the excess earnings formula.  The actuarial report for FY 2014 is out, but the annual report has not been released.  I do not know what the COLA amounts would be going into FY 2015, which is already 8 months in, though there would be no COLA under the SB 1609 formula and some COLA paid under both the excess earnings formula and the PFFA 2% formula.  In FY 2011 and prior, it appears that all the amounts represent the maximum 4% COLA allowed under the excess earnings formula.

Before we go further, here is a description of each COLA formula:

1. The excess earnings model takes half of any earnings over 9% in a fiscal year and sequesters it in a fund used exclusively to pay COLA's.  Up to a 4% COLA can be paid each year.
2. The PFFA 2% formula is still just a proposal, but it would limit COLA's to up to 2% based on available funds taken from active workers' pay, and it would delay COLA's for up to seven years or age 60, which ever is sooner.  There will be a three-year period where no COLA's will be paid in order to build a reserve, and no more than 25% of the reserve could be used in one year.
3. The SB 1609 formula, which is being contested in court but is technically still in effect for anyone who was not already retired when SB 1609 went into effect, uses a sliding scale for COLA's based on both the past FY's earnings and the funding level of PSPRS.  The scale goes as follows:
• If the ratio of the actuarial value of assets to liabilities is 60-64% and the total return is more than 10.5% for the priorfiscal year, 2% maximum increase to all eligible retirees and survivors.
•  If the ratio of the actuarial value of assets to liabilities is 65-69% and the total return is more than 10.5% for the prior fiscal year, 2.5% maximum increase to all eligible retirees and survivors.
• If the ratio of the actuarial value of assets to liabilities is 70-74% and the total return is more than 10.5% for the priorfiscal year, 3% maximum increase to all eligible retirees and survivors.
• If the ratio of the actuarial value of assets to liabilities is 75-79% and the total return is more than 10.5% for the prior fiscal year, 3.5% maximum increase to all eligible retirees and survivor.
• If the ratio of the actuarial value of assets to liabilities is 80% or more and the total return is more than 10.5% for the prior fiscal year, 4% maximum increase to all eligible retirees and survivors

So we can see from the table that the excess earnings formula is, by far, the most generous to retirees.  The average normal retirement benefit in 1998 was $2,050/month.  The excess earnings formula increased this by about 90% in 16 years.  The PFFA 2% formula represents a 49% increase, and the SB 1609 formula represents a 31% increase.

If we use the COLA figures from Social Security, which are based on the Consumer Price Index, we can see inflation rates as follows and how they would affect the original $2,050/month benefit:

Year	%	COLA	Benefit
1998	1.30%	$   26.65	$  2,076.65
1999	2.50%	$   51.92	$  2,128.57
2000	3.50%	$   74.50	$  2,203.07
2001	2.60%	$   57.28	$  2,260.35
2002	1.40%	$   31.64	$  2,291.99
2003	2.10%	$   48.13	$  2,340.12
2004	2.70%	$   63.18	$  2,403.31
2005	4.10%	$   98.54	$  2,501.84
2006	3.30%	$   82.56	$  2,584.40
2007	2.30%	$   59.44	$  2,643.84
2008	5.80%	$ 153.34	$  2,797.19
2009	0.00%	$        -	$  2,797.19
2010	0.00%	$        -	$  2,797.19
2011	3.60%	$ 100.70	$  2,897.88
2012	1.70%	$   49.26	$  2,947.15
2013	1.50%	$   44.21	$  2,991.36

Total                         $ 941.36     

This shows that the PFFA 2% formula appears to be the formula that most closely matches the inflation of the period.  The 2013 benefit represents a 46% increase from the original $2,050 monthly benefit.  During this period, inflation averaged about 2.4% a year.  As can be seen, the excess earnings COLA is way out of sync with inflation, while the SB 1609 formula is lagging behind inflation.  So far, it looks like the PFFA proposal is not too bad, but let's look back at the 16 years prior to 1998.  During the period between 1982 and 1997, inflation averaged 3.6%.  This time period caught the very tail end of the "Great Inflation" era of the 1970's and early 1980's in which inflation peaked at 14.3% in 1980.

Year	%	COLA	Benefit
1982	7.40%	$   151.70	$  2,201.70
1983	3.50%	$     77.06	$  2,278.76
1984	3.50%	$     79.76	$  2,358.52
1985	3.10%	$     73.11	$  2,431.63
1986	1.30%	$     31.61	$  2,463.24
1987	4.20%	$   103.46	$  2,566.70
1988	4.00%	$   102.67	$  2,669.37
1989	4.70%	$   125.46	$  2,794.83
1990	5.40%	$   150.92	$  2,945.75
1991	3.70%	$   108.99	$  3,054.74
1992	3.00%	$     91.64	$  3,146.38
1993	2.60%	$     81.81	$  3,228.19
1994	2.80%	$     90.39	$  3,318.58
1995	2.60%	$     86.28	$  3,404.86
1996	2.90%	$     98.74	$  3,503.60
1997	2.10%	$     73.58	$  3,577.18
Total		$1,527.18

This is where we have to start thinking about unintended consequences.  Using the inflation numbers from 1984 to 1997, you would need about $3,577 in 1997 to equal what you could buy in 1984 with your starting $2,050 monthly benefit.  The PFFA 2% proposal would only provide you with $2,814, leaving you with about 79% of your original purchasing power.  If we use 4% average inflation over the 16-year period, you would need $3,840 just to keep up with inflation, while the PFFA 2% proposal would still leave you with only $2,814 and now with only 73% of your original purchasing power.  Small changes in inflation can make a big difference.  Of course, higher inflation over longer periods of time will leave you even poorer.  Social Security Administration shows annual inflation in 1979, 1980, and 1981 of 9.9%, 14.3%, and 11.2%, respectively. 

The most obvious argument for the PFFA proposal would be that the table still shows that it would pay more than the SB 1609 formula, especially since SB 1609 requires PSPRS to meet two benchmarks, 60% funding level and 10.5% rate of return, before a COLA is paid.  That is a fair enough criticism that needs further analysis.

 FY 2014 shows PSPRS with only a 49.2% funding level, but we must remember that if part of SB 1609 had not been overturned by the Arizona Supreme Court, the funding level would higher.  If the excess earnings model had not been reinstated for those retired when SB 1609 went into effect, PSPRS' funding level would be 6.1% higher at 55.3%.  If you add back in the 2.7% health insurance portion that must now be separated by IRS rules but was counted as part of the total funding level when SB 1609 when into effect, PSPRS would now sit at a 58% funding level.  This is not quite 60% but is close, and it is an increase over the previous year's funding level of 57.1%, which means it was moving in the right direction before the Fields decision and would soon be over 60%.  Obviously another major market downturn would send the funding ratio back down, but this would take us back to the existential crisis of PSPRS' ultimate survival.

Meeting the 10.5% threshold is more problematic. Except for 2013 and 2014, the reason the SB 1609 formula would have paid no COLA is because PSPRS did not hit the 10.5% rate of return, and since 2001 it would have paid COLA's in only four of the last 13 years. However, we must remember several things.  First is that PSPRS needs some excess earnings to pay down its deficit.  It can be debated how much this margin should be, but even with the 10.5% threshold, this represents only a 2.65% excess margin over the expected rate of return (ERR) of 7.85% available to pay down current liabilities and allow for a cushion of excess earnings against years when the fund earns less than 7.85%.  The true stupidity of the excess earnings formula is that it deemed any earnings over the old ERR of 9% as "excess" and allowed half of that amount to be set aside for COLA's as if PSRPS would never have a time when it would earn less than its ERR and need some higher-than-expected earnings to make up for shortfalls in bad years.  Second, we have to remember that the time period we are considering here is the worst financial period since the Great Depression.  In the absolute worst of financial times, the SB 1609 formula would still pay COLA's while working to bring PSPRS back to solvency.  Third, once PSPRS' funding ratio begins to rise, it will be able to pay higher COLA amounts, which could make up for years when a COLA was not paid because the ERR did not exceed 10.5%.  Once PSPRS, reaches 80% funding, the COLA will be 4%, double the 2% limit of the PFFA formula.

Lastly, we once again must consider the unintended consequences of inflation.  We have already seen how a period of sustained inflation above 2% would slowly rob retirees of the value of their benefits.  We also have to think about what inflation will do to rates of return.  Higher sustained inflation means that investors like PSPRS will find it easier to get higher rates on low-risk and risk-free investments.  This means the other riskier investment in its portfolio will likely see a rise in their rates of return as well.  All this means that PSPRS will see it rates of return increase with no real effort on their part; inflation will take care of that for them.  You can check out this chart of historic certificate of deposit (CD) rates of return at Bankrate.com to see what I am talking about.  This will make it easier to reach the 10.5% threshold necessary to pay COLA's under the SB 1609 formula.  Under the PFFA formula, regardless of what PSPRS earns, retirees will receive 2% year in, year out, regardless of what PSPRS earns.  Remember that the PFFA reform proposal will make its changes via constitutional amendment, permanently locking them in.  Any change to the 2% formula would likely be met with resistance from other interests both inside and outside of PSPRS and would require another voter-approved initiative to change.

I am an active worker, and my perspective is different from someone already retired who is only looking at his or her monthly benefit check.  To some it may seem like a better deal to just accept the 2% annual COLA and not take your chances, but I think that is shortsighted.  In the end, PSPRS is a debtor to all its members, active and retired, and inflation helps debtors by allowing them to pay off obligations in the future with devalued dollars.  This is a stealth way for PSPRS to achieve solvency while its retirees slowly get poorer.  Also, remember that the PFFA proposal places a three-year hold on COLA's for everyone, and it will delay COLA's for up to seven years for new retirees.  There is also no guarantee that the COLA will be 2% every year.  There are a lot of financial angles to think about if you are a retiree.

I am not defending the SB 1609 COLA formula because I think it is perfect.  I am on record as advocating an annual COLA determination by the Board of Trustees (or another independent board) that would take into consideration PSPRS' financial condition, inflationary conditions, and rates of return to make sure retirees can be kept as whole as possible in the face of inflation while not shafting taxpayers and active and future workers.  SB 1609, which came out of the Arizona Legislature, is simply better designed, fairer, and actually made an effort to equitably share some necessary sacrifices.  The PFFA's reform proposal is a cynical, political ploy that tempts its retirees to sell out their younger brothers and sisters for a "guaranteed" 2% COLA.

I apologize for the length of this post, but as I said at the beginning, the PFFA's Operation Blue Falcon is more complicated as it relates to retirees.   Whether you agree with my conclusions or not, I hope that the numbers will give you some better information to decide what is best for you.  Rest assured that there will be more to come about this in future posts.

Why you should hate the Professional Fire Fighters of Arizona's (PFFA) PSPRS reform proposal, Part I

The art of economics consists in looking not merely at the immediate but at the larger effects of any act or policy: it consists in tracing the consequences of that policy not merely for one group but for all groups. 

                                                               Henry Hazlitt,  
                                                               Economics in One Lesson

If you are an active employee who is keeping an open mind about the Professional Fire Fighters of Arizona (PFFA) PSPRS reform proposal, you may be asking yourself this: 

If SB 1609 already requires me to pay increased contributions into PSPRS, why do I care whether the extra contribution amount goes to pay COLA's to retirees or is used to pay down PSPRS' deficit since it comes out of my check either way?

Okay, maybe you weren't asking that question, but it does allow me to go into some of the unintended consequences of the PFFA's reform proposal.

PFFA President Bryan Jeffries has stated that the PFFA reform proposal, ". . . would fund retirees' cost of living adjustments out of the pockets of current working public safety workers, not taxpayers."  This would be done by taking the aforementioned extra contribution amount already being paid by active workers (currently 3.4%, but topping out at 4% on July 1, 2015) to pay down PSPRS' deficit, and instead, use it to fund COLA's for retirees.  The destructive excess earnings model of paying COLA's would be eliminated.  Active workers would see no net change in their paychecks, as they have to pay the additional 4% for their whole careers anyway; taxpayers would be off the hook for the COLA's; and retirees would still be able to get COLA's, though they will be at a reduced amount.  Win,win, and not a total loss, right?

Not quite.  If you are an active employee making contributions into PSPRS, it is true that your contribution will not change.  However, you will have to consider the unintended consequences of your career earnings becoming the dedicated source of income for retiree COLA's.  Governments (and public employee unions) love to have dedicated sources of income.  This is usually done via some type of tax like a gas tax hike for road repairs, a tax on cigarettes for health programs, or a sales tax increase for some particular program (like was attempted in 2012 with Proposition 204, which would have made the temporary one cent sales tax increase permanent to fund education).

The dedicated funding source is fine as long as the economy is good.  When there is a downturn, the tax will remain, even if the taxpayers are finding their own income diminished.  If we are talking about gas, cigarette, or even sales tax, the taxpayer has some means to offset their loss of income by driving, smoking, or buying less in general.  But what happens to active employees when there is an economic downturn?

Active employees, who have been dutifully funding retiree COLA's with 4% of their earnings, will now see the unintended consequences of the PFFA reform proposal.  Their employers, suffering from decreased tax revenues, will have to find ways to trim their budgets.  This is particularly harsh for those in public safety because economic downturns usually mean that PSPRS suffers investment losses, which in turn, means higher annual required contributions (ARC's) for employers. The employers are hit by this double squeeze of lower tax revenue and higher ARC's.  This spells disaster for active public safety employees.

Wages and benefits are by far the largest part of law enforcement and fire service budgets.  When an employer has to trim public safety budgets, it really has no other option than reducing payroll costs, either individually or in the aggregate.  While it may be good to be the recipient of a dedicated source of income, it is not so good to to be the dedicated source of income.  Active employees will find this out if the PFFA's succeeds in making their proposal part of the Arizona Constitution.

If there is another financial crisis, active employees are going to get hammered because they will be the only source of cost savings in the budget.  However, retirees may not even notice the financial hardship visited on active employees because of the design of the PFFA reform proposal.  Looking at the fiscal year (FY) 2014 actuarial report, we can see that active members contgributed about $152 million into PSPRS.  If COLA's were being paid per the PFFA reform proposal, 4% of this amount, or about $6 million, could be used to pay retiree COLA's.  There were about 10,500 retirees at the end of FY 2014 with an average yearly retirement benefit of $51,600.  The $6 million allocated for COLA's would not be enough to pay a full 2% to all retirees.  $6 million divided among 10,500 retirees would only be about a $571 annual increase for each retiree.

Now let's redo these calculations.  Suppose a bad economy caused employers to give our active employees a 2% pay cut in FY 2014.  This would reduce our total active member contributions to about $149 million from $152 million.  4% of the reduced amount would be about $5.96 million.  With this lower amount to pay COLA's, retirees would receive a $567 annual increase versus $571.

However, the average FY 2014 salary of our active employees is about $75,000 per year.  A 2% pay reduction means that our average employee loses $1,500 a year.  Retirees will see their COLA reduced by $0.33 per month while the average active employee will see his monthly salary drop by $125.  Even if we drop the active employees' pay 10% ($625 a month), our retiree will only see his monthly COLA reduced by about $4.17 a month.

Here we can see the truly insidious effects of the PFFA reform proposal.  It shifts not only the burden of retiree COLA's on to active employees, but also the punishing effects of any future financial crises.  Retirees will be insulated from most of the effects of any financial crisis since any reduction in their COLA's will be minimal in comparison to active employees.  Active employees will take the brunt of nearly all the downside of financial downturns.  Retirees will take virtually none.  This is the same problem with the current excess earnings COLA model that has made it such a problem for PSPRS: all the upside to retirees, all the downside to PSPRS.  Only now, instead of the costs of the bad model hitting PSPRS, the PFFA wants active employees to absorb them.

The PFFA's desire to make active employees the dedicated source of income for retiree COLA's is so egregious that it is could be used as an example of historian Robert Conquest's Third Law of Politics which says, "The simplest way to explain the behavior of any bureaucratic organization is to assume that it is controlled by a cabal of its enemies."  With a friend like the PFFA . . .

In the next post we will discuss how this plan is bad for retirees as well.

The PSPRS fix is in: The Professional Fire Fighters of Arizona's (PFFA) Operation Blue Falcon continues apace

The recent death of actor James Garner gave me cause to begin  re-watching his great 1970's detective show The Rockford Files on Netflix.  While I had watched the show as a kid back when it was originally run (at 9:00 PM on Friday nights on NBC, if memory serves me right), re-watching has caused me to notice certain things that I either missed or forgot.  In particular, the episode, "The House on Willis Avenue," was much more interesting in 2015 than it was in 1978, when it was originally broadcast.  Briefly, it involves a murder tied to a private data collection agency that was criminally abusing its access to private personal information.  Rockford exposes the company and brings the perpetrators to justice, but the most interesting thing is a slide that appears at the end of the episodes that reads:

Secret information centers, building dossiers on individual exist today.  You have no legal right to know about them, prevent them, or sue them for damages.  Our liberty may well be the price we pay for permitting this to continue unchecked.

Member, U.S. Privacy Protection Commission

If you are still with me, you are probably wondering what this has to do with PSPRS.  The simple point I think this makes is how years of complacency has made what was once outrageous seem like no big deal.  The level of individual privacy we accept now is lower in 2015 than in 1978, when the ability to maintain your privacy was much greater.  Instead of expecting the government, which should protect us from privacy violation, we just hope that they are not abusing our privacy in a more egregious manner.

This makes a good segue into how this is relevant to PSPRS: the February 20, 2015 Arizona Republic "Into the Mind" editorial with Professional Fire Fighters of Arizona (PFFA) President Bryan Jeffries entitled, "How firefighters would reform Arizona pensions."  I have already written about the PFFA's  reform proposal to "fix PSPRS" in this post, which mostly notes how it provides no improvement over SB 1609,  and I was hopeful that it would have already died on the vine.  Unfortunately, like many bad ideas, it refuses to die, PFFA appears determined to release its Frankenstein monster out of the lab.

First, let me credit Mr. Jeffries for his honesty.  He openly admits to the inter-generational wealth transfer of the PFFA reform proposal by stating, "Our plan would fund retirees' cost of living adjustments out of the pockets of current working public safety workers, not taxpayers."  If you are not familiar with the PFFA reform proposal (which is available at the League of Arizona Cities and Towns Pension Task Force website), it would eliminate the current excess earnings models for cost of living allowances (COLA's) and take the SB 1609-mandated contribution increases of active PSPRS members now being used to pay down PSPRS' deficit, and instead, use them to pay COLA's to retirees.  It would also delay COLA's for up to seven years or until age 60, whichever is sooner.

The additional contributions mandated by SB 1609 will top out at 4% starting next fiscal year.  This 4% taken from current employees will then be used to pay a delayed COLA of up to 2% to retirees.  You do not need to be a mathematician to figure out that someone who works for 25 years paying 4% per year will never recoup in future COLA's what he paid in past contributions unless he lives for a really, really long time.  Compare this to SB 1609, which guarantees a minimum COLA of 2% if PSPRS is at least 60% funded and earned at least 10.5% in the prior fiscal year.  If you are an active PSPRS member, especially one just starting his or her career in public safety, does the PFFA reform proposal sound like a good deal to you?  Would you like to take a guaranteed loss on your total lifetime income as the PFFA wants or would like your future COLA's to track with the overall financial health of PSPRS?

Mr. Jeffries also proposes a false choice of on whom the responsibility for funding retiree COLA's should fall: active workers or taxpayers.  This fallacious proposition fails to identify the fundamental problem with PSPRS which is that it has only one source for COLA's, and it is neither active workers nor taxpayers.  While the excess earnings formula connotes something bad about using excess earnings to pay COLA's, in fact, excess earnings are the ONLY source from which PSPRS can pay COLA's .  The current excess earnings formula suffers from a horribly bad design because it takes half of any earnings over 9% in a fiscal year and segregates it into a fund that can only be used to pay COLA's.  However, if PSPRS loses money, it absorbs 100% of the loss.  This is why PSPRS continued to pay COLA's even as its funded ratio dropped each year.  SB 1609 addressed the problem by tying COLA's to not only the excess earnings percentage but also to PSPRS' funded ratio.  While the Fields decision rolled back SB 1609' s changes, it did not change the fact that an underfunded pension can not pay COLA's. 

The PFFA leadership has blithely offered up the current and future wages and benefits of its active members to maintain the payment of COLA's from a perilously underfunded pension.  Rather than advocating a better solution to the excess earnings model than SB 1609, which correctly prioritized bringing PSPRS back to financial health over paying COLA's, the PFFA has decided that COLA's are sacrosanct and wants to use its active, dues-paying members as a permanent source of COLA funding.  I would hope that most retirees would object to this.  Whether you are a member of PSPRS who just started paying contributions or someone who did his time and has been retired for 25 years, I think that we can agree that we are all in this together.  No one group has a greater claim to PSPRS' assets or a lesser obligation for its liabilities.  If you are in for a penny, you are in for a pound.  In the end, the best way to ensure that COLA's are paid is to bring PSPRS back to financial health as soon as possible, and it does not have to be accomplished through some form of inter-generational theft.

The PFFA leadership has perhaps spent too much time among the media and politicians to realize that, like Colonel Nicholson in The Bridge on the River Kwai, good people can forget whom they represent and for what they are supposed to stand.  PFFA's constituency is out here, not at The New York Times, Arizona Republic, PSPRS office, mayor and city council chambers, or the Arizona Statehouse.  Those entities may be impressed that Mr. Jeffries and the PFFA are willing to sacrifice workers' earnings to garner their favor, but rank and file PSPRS members should see the PFFA reform proposal as a breach of faith that helps neither active workers nor retirees.

So this brings us back to the analogy that started this post.  Is this what we have come to now?  An organization that is supposed to represent the interests of unionized firefighters in Arizona is freely giving up workers' hard-earned and diminished income.  Would unionized public safety workers have meekly accepted a proposal like this 40, 50, or 60 years ago?  Would law enforcement unions have stood by helplessly as another organization transformed the financial landscape beneath the feet of its own members?  Has such a sense of complacency set in that we can not even recognize when we are being hurt by those whose job it is to stand up for us?  There should be a lot more to come on this subject in the future.  Stay tuned.

PSPRS investment returns through December 2014

The following table shows PSPRS' investment returns, gross of fees*, versus the Russell 3000 for December 2014, the halfway point 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%

There is usually about a two-month lag in PSPRS reporting its investment returns.  2014 ended with no montly change in the Russell 3000 and a slight loss for PSPRS.  PSPRS' total returns were once again brought down by its non-US equity portfolio, which decreased 3.02% in December 2014.  The non-US equity portfolio has an 8.35% loss in the current fiscal year versus a 4.30% gain in the US equity portfolio.  The real assets portfolio has suffered a 3.22% loss for the current fiscal year and is the only other asset class with a loss for the current fiscal year.

PSPRS' monthly return for January 2015 is likely to be quite poor.  The Russell 3000 shows a 2.78% loss  for the month of January 2015, though February 2015 has been so far been a great month.  The Russell 3000 is currently higher than it was on December 31, 2014, but the markets have been so volatile lately that guessing where February will end is a fool's errand.  Regardless, PSPRS is likely to end the month of February 2015 with a fiscal year-to-date return of less than one percent with only four months to reach its expected rate of return of 7.85% by June 30, 2015.

* Returns, gross of fees, are used because PSPRS usually does not report returns, net of fees, 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.

PSPRS investment returns through November 2014

The following table shows PSPRS' investment returns, gross of fees*, versus the Russell 3000 for November 2014, the fifth 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%

There is usually about a two-month lag in PSPRS reporting its investment returns.  I try to post the PSPRS returns each month, but there is a one-month delay because the PSPRS Board of Trustees did not have a monthly meeting in December 2014.  This table includes the returns for October and November 2014.

As of the end of November 2014, PSPRS' non-US equity portfolio, which makes up 14.23% of PSPRS' total portfolio, has returned -5.49%.  PSPRS' real assets portfolio, which makes up 7.33% of PSPRS' total portfolio, has returned -2.61%.  Every other asset class, including real estate, has shown a positive return through November 2014. 

The Russell 3000 is made up of the 3,000 largest US companies.  The US market has recently done much better than the rest of the world, and PSPRS' negative return on its non-US equity portfolio is in line with the non-US equity benchmark of -5.53%.  PSPRS' real assets portfolio is lagging its benchmark by 3.18%.  It should be pointed out that other assets classes have negative benchmarks but positive returns for PSPRS, so there is some tradeoff between asset classes.

The up-and-down fiscal year continues.  The Russell 3000 website shows a 0.0% return for the month of December 2014, so it is anybody's guess what PSPRS will earn for December.  Those next returns will mark the halfway point of the fiscal year.  By the end of 2013, PSPRS's fiscal year-to-date return had nearly reached its expected rate of return.  PSPRS will not be in the same enviable position at the end of 2014.

* Returns, gross of fees, are used because PSPRS usually does not report returns, net of fees, 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.

Parham's Paradox: true confessions from PSPRS' Chief Investment Officer

One of the more remarkable things I have ever read about PSPRS is this piece by PSPRS Chief Investment Officer (CIO) Ryan Parham, "The truth about PSPRS investment performance," that appeared in the December 18, 2014 Arizona Capitol Times.

Whenever an interested party proclaims to tell you the "truth" about a matter in which they are involved, you should be suspicious.  However, I read this with an open mind since I do not reflexively believe that the PSPRS administration and staff are responsible for PSPRS' financial woes, and after reading it through, I can not really dispute Mr. Parham's points about the relative quality of PSPRS' recent investment performance, the punishing effect that permanent benefit increases (PBI), more commonly referred to as COLA's, have on PSPRS' funded ratio, and the need to change the current COLA formulaton.

However, the most amazing thing that Mr. Parham writes is this:

. . . it is important to remember our innovative, low-risk, moderate return strategy is by conscious design, due to a pension benefit that PSPRS alone must pay to pensioners. This benefit, called the Permanent Benefit Increase, or “PBI,” siphons and distributes half of all returns in excess of 9 percent to eligible retirees. Not only are these increased payment levels made permanent, the investment gains only serve to increase – not decrease – unfunded future liabilities.

This rang true in fiscal years 2013 and 2014, in which PSPRS net performances were a positive 11 percent and 13.3 percent, respectively, while the system’s funded ratio dropped on both occasions. The cruel irony of this is that unless the PBI is modified to allow the PSPRS to retain and reinvest all of its gains, it is unlikely that we will ever be able to significantly impact the decline in our funding ratio.

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. (italics mine)

This passage is astonishing, and I had to read this a couple of times to ensure that I understood what Mr. Parham was saying.  Incredibly, he is saying that PSPRS' investment strategy is not designed just to balance investment risk and reward, but is also consciously designed to target as closely as possible the 9% threshold that triggers the excess earnings transfer into the Reserve for Future Benefit Increases ("the Reserve").  This is a stunning admission that PSPRS is deliberately low-balling its potential investment returns in order to limit contributions to the Reserve from which COLA's are paid.  I would like reiterate that this information is coming directly from the chief investment officer, a man who probably knows more about PSPRS than anyone else working there, in a piece that is giving us "the truth about PSPRS investment performance."

If you are a retiree, this likely outrages you. The CIO just confessed that PSPRS is purposefully trying to minimize its ability to pay COLA's.  But for everyone, this situation is just perplexing.  Mr. Parham is saying that with the current COLA formulation, earning over 9% actually has a negative effect on PSPRS' finances.  How can that be?  50% of anything over 9% would seem to be better than nothing, but he does not give any numbers to explain this.  If I were to speculate, I would guess that this would be due to the compounding effect over time of increased benefits, but I would need to see a more detailed explanation by Mr. Parham to better understand this situation.  Regardless, with a current expected rate of return (ERR) of 7.85%, this gives PSPRS a pretty small window of 1.15% to work with to help increase its funding level.

We should note that Mr. Parham's piece appeared in the Arizona Capitol Times, a newspaper which describes itself as "your inside track to Arizona politics."  By publishing his piece in a newspaper geared toward Arizona's governmental/political class and not a more mainstream paper like the Arizona Republic, it appears that Mr. Parham is appealing to the state's movers and shakers with a bit of inside information about the real reason why PSPRS' returns are so low.  I guess the rest of us just could not contemplate the subtleties of such a complex strategy, so Mr. Parham did not even bother to place a link to this piece on the PSPRS website like they usually do with other pieces written by PSPRS staff and trustees.

In the end, I have no choice but to give Mr. Parham the benefit of the doubt that his information is correct and that investment gains over 9%, paradoxically, are harmful to PSPRS' financial condition.  Furthermore, if it helps to change the COLA formulation in a beneficial manner (i.e. NOT like the Professional Fire Fighters of Arizona (PFFA) plan of intergenerational theft), this will have been a good thing.  However, Mr. Parham has also implied that PSPRS could produce higher returns than it currently does.  His words should end up on the wall of every PSPRS trustee and state legislator, as well as the governor and state treasurer.  It should not be lost down a memory hole if PSPRS does not produce stellar returns when the COLA formula is finally changed.  Just imagine what PSPRS would look like if its investment staff actually tried to earn as much money as possible.  That's the standard Mr. Parham has set for the investment staff, so I hope they are ready to perform.