Working overtime to bankrupt PSPRS

The latest piece on the upcoming PSPRS reform plan/referendum, "Voters to decide on pension plan," by Pete Aleshire appeared in the December 31, 2015 Payson Roundup.  It does not give much new information, but it does include this:

The details of the proposed reform measure have not been released. However, they reportedly include limits on “spiking” salary in the final three years by counting unused sick leave and vacation time as well as piling on overtime.

I found this interesting as this is the first mention I have seen that pension reform will deal with overtime, specifically with how the accumulation of overtime pay in an employee's high years' average (a high-three or high-five years' average, depending on when the employee was hired) artificially inflates the employee's pension benefit.  In the past, discussions about pension spiking usually focused on the use of sick and vacation leave sellbacks to raise an employee's high years' average in order to spike the employee's pension benefit.  While this was illegal, some employers allowed it until lawsuits forced them to adhere to state law, though the City of Tempe and its firefighters are determined to continue the practice via sleight of hand.  However, the disproportionate loading of overtime into the high years' average is an equally bad or even worse form of pension spiking.

If there is a provision to eliminate or limit overtime pay amounts in employees' high years' averages in the PSPRS reform plan, it may be the result of a recommendation made in the Arizona Auditor General's "Performance Audit and Sunset Review of the Public Safety Personnel Retirement System." ("the Performance Audit")  The Performance Audit listed among its "additional actions necessary to improve system plans’ financial condition and long-term sustainability" was to ". . . develop materials for PSPRS plan employers on overtime pay and implement formal policies and procedures to ensure benefit calculations are correct."  The Auditor General writes:

. . .  overtime pay is not included in the definition of compensation for CORP or EORP. Including overtime pay in the benefit calculation may increase the risk that the member’s final average salary is higher than would be expected from normal salary increases, which may generate unfunded liabilities for employers. If a PSPRS plan member worked a large number of overtime hours during the period that determined that member’s final average salary, these hours would increase the member’s reported compensation and resulting pension benefit.  Although the PSPRS plan would collect more contributions from the member’s increased compensation, this increase could generate unfunded liabilities for the member’s employer.  Specifically, one of the assumptions that the System’s actuary uses to estimate pension obligations forecasts the levels of compensation upon which members’ pension benefits will be based. According to the System, overtime pay is reflected in this assumption; however, there is a risk that the overtime pay in the period used to determine a members’ final average salary may surpass this assumption and generate unfunded liabilities for their employers.  Further, according to the National Institute on Retirement Security, even though pension spiking is not common, a few isolated instances can create the impression of widespread abuse.

The December 2012 Final Report of the Defined Contribution and Retirement Study Committee gave us some numbers when it comes to pension spiking in PSPRS.  It defined spiking as a:

. . . compensation increase by more than 25 percent during the last three years of employment. This is more than twice the average compensation increase that the plans use in determining wage inflation in the final years of employment.

The Committee found that between 2008 and 2011 the percentage of retirees who increased their compensation by more than 25% in their last 36 months ranged from 22.6% to 29.77%.  This shows that it is not an "isolated" practice among only a few PSPRS members, but rather done by one in four PSPRS members.

If a PSPRS member earning $60,000 per year spiked his salary by just 10% over his last three years, he would increase his annual pension benefit by $3,750 per year (62.5% of $6,000) if he retired after 25 years of service.  He would pay an extra $2,097 in member contributions (11.65% of $18,000).  If his employer's contribution rate is 50%, the employer would pay $9,000.  The PSPRS member is obviously happy since he makes up his extra contributions on the 10% spike in the first seven months of his retirement.

In order to figure the financial damage to PSPRS, we need calculations that get more complicated.  Using Bankrate.com's compound savings calculator, we can see that the combined $11,097 in employee and employer contributions will actually be $12,403 when that employee finally retires, if the contributions are compounded monthly at PSPRS' current expected rate of return (ERR) of 7.50%.  That $12,403 will now have to fund the extra $3,750 per year that the now-retired PSPRS member will get for the rest of his life.  Now we see the problem that comes with even a small amount pension spiking.

If we use an annuity calculator and the same ERR, the amount that needs to be there when the employee retires is actually $42,552, if he lives for another 25 years.  With only $12,403 the retiree should only expect to receive his extra spiked benefit for 3.79 years before that money ran out. This assumes many other things such as no COLA's, decreases in the ERR, a lower employer contribution rate, or a spouse that outlives the retiree.  The deficit on the spiked benefit amount must be made up by either taxpayers or active PSPRS members.

This is how we slowly kill our own pension system, and it is the problem the Auditor General identifies with overtime pay.  It simply makes no financial sense for PSPRS to include overtime pay in the high years' average used to calculate pension benefits, and the other two pension systems PSPRS manages, EORP and CORP, wisely forbid this practice.  Spiking pension benefits with overtime pay is another of the perverse incentives embedded in PSPRS, like the Deferred Retirement Option Plan (DROP), that leads employees to collectively chip away at the financial solvency of their own retirement system.

There are several underlying principles here that are very important for us to remember.  The first is that a pension system relies on contributions to compound over time.  The funds paid early in an employee's career are much more valuable since they should (hopefully) grow over the decades to an amount sufficient to cover the lifetime pension benefits earned.  Overtime spiking throws this formula out of whack by dramatically raising the pension benefit amount during a brief period at the end of the employee's career.  Not allowing those end-of-career contributions to compound over the years leaves the pension with a deficit that needs to made up somewhere else.

The second principle is that employees should not be able to influence their own pension benefit calculations.  Economics tells us that individuals will naturally attempt to maximize their own gain, and as employees, this is not always done in a manner that is mutually beneficial to the organization that employs them.  Every employee who spikes his pension does so at the expense of the organization, taxpayers, and fellow and future employees.  This is not a criticism of any individual taking advantage of a flawed system but simply a hard financial truth.  Every unfunded dollar of pension liability caused by spiking will be a dollar not spent of equipment, facilities, raises, or other services provided by the government.  If overtime were not pensionable, an employer who has a contribution rate of 50% would immediately save 50 cents on every dollar paid in overtime, and the employee would also save the 11.65% contribution paid on his overtime pay, nevermind the long-term savings to the pension. 

The last principle is that public safety unions have failed their members by not addressing this issue.  Like all unions,public safety unions expect loyalty and discipline from their members in order to enhance the collective good.  This can and should work, but as I have mentioned before, unions tend to work not for the collective good but rather as a seniority protection agency.  Pension spiking is a perfect example of this.  It benefits only one group-- those close to retirement, and as mentioned before, it actually harms members collectively.  The justification in the past has always been that someday the junior person will be senior and will be taking advantage of the same benefit.  However, we now have what is essentially a zero-sum game where any benefit taken by one group comes out of someone else's end.  Union leadership, usually made up of senior personnel, has no incentive to change this as it will negatively affect their own retirements, and so they pretend like a problem does not exist until they are forced to deal with it by passing the costs on to someone else.  This it at the heart of the Professional Fire Fighters of Arizona's (PFFA's) pension reform plan, which will transfer costs to another generation of public safety employees (and taxpayers) in order to protect the benefits of those close to retirement.

An organization that was dedicated to the collective good would work to prevent pension spiking, and instead, work at raising pay for everyone.  This would benefit everyone, both in the form of higher current wages and in the future with higher pensions, and it would not be done by shortchanging PSPRS.  Wage increases across the board would boost pay for all ranks and seniority, whether newly hired or getting ready to retire, and increase the amount of funds going into PSPRS.  This would allow for the normal compounding of contributions so necessary to keep PSPRS from slipping further into debt.  As for those who still want to raise their pensions, they will have to do it the old-fashioned way via promotion or other merit-based processes.  Eliminating overtime pension spiking will help to align the interests of all employees, unions, and employers, instead making them work against one other.


I believe that two of the best potential reforms to PSPRS would be the elimination of the DROP and ending all forms pension spiking, whether overtime pay, sick and vacation leave sellback, or anything else that artificially inflates an employee's high years' average.  I am optimistic for the implementation of the former reform though not the latter, but we will have to see what comes out of the Legislature.  Hopefully, we will be seeing something real soon.

A little bit more on PSPRS pension reform before the end of the year

While I was hoping there would be more definitive information available this month, it looks like we will have to wait until January 2016 to find out what the Arizona Legislature has in mind for PSPRS.  However, there were two brief blurbs on Phoenix news radio station 550 KFYI website that give us a smattering of news.  The first gives us an update on the progress of the plan and when we may see it:

(KFYI News/AP) - An overhaul plan for Arizona's public-safety pension plan is almost done.

State Senator Debbie Lesko of Peoria says a deal is close after months of meetings between lawmakers, pension officials, and others. She says the deal may even be ready in January.

A recent report found the system can only pay half its promised pensions, although contribution rates have soared.

The second gives us more clues about what might be in it and when it will appear on the ballot:

(KFYI News) – Arizona voters may see a second ballot measure in the May 17 special election.

Voters will already have their say on Proposition 123, a referendum to amend the Arizona constitution to allow increased withdrawals from the state's land trust fund to boost funding for K-12 education.

The Arizona Capitol Times reports lawmakers may add a referendum on amending the state constitution to change how the state's pension system for police and firefighters is funded.  As it stands now, the Public Safety Personnel Retirement System (PSPRS) is severely underfunded. 

Under the proposal, which is reportedly very close to agreement between legislative leaders and union representatives, benefit levels for public safety employees would be capped, and a 401(k) type of component would be added, where enrollees would have to save some of their own money on top of the pension contribution.

If approved, the changes would affect both new employees and existing public safety employees statewide.  The changes would have to be OK'd by voters because under the state constitution, retirement benefits for existing government employees cannot be changed by the legislature.

This 550 KFYI story references an Arizona Capitol Times story, which unfortunately is behind a paywall.  Not much to go on, but it does look like things will move fast once we get into 2016.  Have a safe and happy New Year.

The 11 most terrifying words: We're from PSPRS and we're here to help with pension reform

The PSPRS Board of Trustees meeting was cancelled for December 2015.  This is disappointing since I was interested to see how PSPRS' investments did during October when the the Russell 3000 returned a whopping 7.90%.  We will now have to wait until January 2016 to find out.  However, there was another meeting today at PSPRS, but this body was something new called the Pension Reform Work Group Committee ("the Committee").  I unfortunately missed the beginning of the meeting so I am not sure who is on this committee, but it appears that at least some of the Trustees, including Chairman Brian Tobin are part of it.  The webinar lasted approximately 90 minutes.

I missed about the first ten minutes of the webinar, but it appears that the prepared portion, which had several Powerpoint slides, was just an introduction with a condensed lesson about PSPRS' recent history.  It was, as most public statements that emanate from the PSPRS bunker, a self-serving display with finger-pointing at past Trustees and administrations for PSPRS' current problems and self-congratulations about their own perceived progress/success.

While most of the prepared portion of the meeting covered areas most of us are already well aware, there were two interesting things said in that portion.  The first was a statement by the Committee that, up until 2011, PSPRS had been neutral when it came to the laws governing PSPRS.  They just followed whatever was mandated by the Arizona Legislature and did not make value judgments on any law.  According to the Committee, this changed in 2011 when PSPRS became more proactive and presented several proposals that influenced the writing of SB 1609.  Obviously, there are problems with this since PSPRS has a fiduciary duty to it members.  This is why the neutral position is the normal default for an organization like PSPRS.  Otherwise, it will be forced to pick sides among the different groups it serves.  This is the heart of this March 20, 2014 claim against PSPRS by retired judge Kenneth Fields.  It includes this passage:

     In its brief to the Arizona Supreme Court, the EORP stated: "EORP and the members of the PSPRS Board of Trustees, which administers the plan . . . are essentially neutral stakeholders standing between the legislature and the EORP member."  EORP Appellants' opening brief at page 2.

      Contrary to it fiduciary duties of loyalty and to avoid conflict of interests with its plan members and plan beneficiaries, and contrary to the statements made by the EORP Trustees that they were actually neutral in the Fields litigation, in truth and in fact the EORP Board of Trustees and individual Trustees consistently and aggressively took positions in the Fields case contrary to the interests of its retiree beneficiaries.  Upon information and belief, based upon the litigation pleadings in the case, the Board of Trustees and Trustees worked closely with the State of Arizona to provide a unified litigation strategy against the EORP beneficiaries.

     In truth and in fact, in every instance in the Fields case, in every pleading and filing, the EORP Board of Trustees and Trustees took positions opposing beneficiaries, argued against the beneficiaries, and acted as lead adversary counsel in the case both in briefing in the trial and the appellate courts, and in oral argument and trial before the Supreme Court.

      The EORP Board of Trustees and individual Trustees never advocated a single position that favored its own beneficiaries.  The EORP Trustees admitted as much in their opening brief to the Supreme Court: "But while the EORP Defendants do not opine on the ultimate result . . . . the EORP defendants seek to provide the Court with the facts, legal precedent and analytical tools that it will need to decide the issure presented."  EORP Appellants' opening brief at page 3.  The Trustees then argued in their brief for the Supreme Court to reverse the decision of the trial court and opposed every position taken by the beneficiaries.

 As Trustees, a "neutral" position would have been just that, to take no position with respect to the lawsuit.  The Board of Trustees and the Trustees never took a neutral position on any issue of fact or law in the Fields case.

 In another pending case before the Superior Court, involving active members of the EORP, the Board of Trustees and Trustees are undertaking similar tactics.  The fiduciary breaches in the Fields case are continuing in other parallel litigation.

At the time of this claim, I was under the impression that PSPRS was just defending the legal requirements foisted upon it by the Arizona Legislature.  Now it seems that SB 1609 was legislation PSPRS had a hand in initiating and crafting, knowing full well that it would negatively impact it own beneficiaries.
 
Of course, the proactive PSPRS is the image the Committee wants to portray now that more pension reform legislation is coming.  Reform is in the air, and PSPRS must want to look like they were there from the beginning.  However, contrast the supposedly proactive PSPRS to the one presented in the September 2015 Performance Audit and Sunset Review by the Arizona Auditor General.  This passage from the audit is very revealing:

. . . the System’s actuary had not been factoring in the cost of future benefit increases until recently. Specifically, according to the System, a 2007 audit of the System’s actuary found that it had not incorporated benefit increases when determining contribution rates,
which resulted in underestimated and thus unfunded liabilities.  Despite this 2007
audit finding, the System’s actuary did not begin including the costs of expected future benefit increases when determining contribution rates until fiscal year 2014. The System indicated that it believed Laws 2011, Ch. 357, would address these issues and make benefit increases unlikely in the future. However, given the Fields decision, starting in fiscal year 2014, the plans’ actuarial valuations reflect expected future benefit increases and has two different assumptions, one for members retired on or before July 1, 2011, and one for those retiring after that date. (boldface mine)

The first problem here is that no one in PSPRS' administration noticed that their actuary was not accounting for permanent benefit increases (PBI's), now identified as the single biggest driver of PSPRS' unfunded liability, but even if we put that aside, why did PSPRS wait four years until 2011 to address this problem?  Where was the proactive PSPRS when it could deal with a problem that was within its own purview?  We can all make our own guesses why, but being able to blame a financial crisis rather than their own poor oversight and management might have something to do with it.  So years of failing to even notice they had problem was followed by four more years of inaction, which was then followed by a lobbying effort to legislate a solution to a problem they caused.

The other interesting statement during the prepared portion of the Committee meeting was a comment from another Committee member about the reduction of PSPRS' rate of return.  This Committee member essentially stated that the reduction of the expected rate of return (ERR) was a natural process based on the actuarial data gleaned from past experience.  This is a rather misleading proposition when we understand that PSPRS controls its own investment portfolio.  PSPRS will certainly have to reduce their ERR if they invest in a manner that limits their returns to no more than 9%, as Chief Investment Officer Ryan Parham has publicly said PSPRS is "incentivized" to do.  As they continually underperform the 9% threshold, whether deliberately to avoid paying PBI's as Mr. Parham implies or just because their strategy is bad and could never reach 9% anyway as it appears more likely, they will have to reduce their ERR to match the reality they have created.  This is not some condition like mortality rates over which PSPRS has no control, but a situation they are producing with their investment policies.

Now if PSPRS feels like it needs a lower ERR in order to achieve a safe and steady return, that is fine.  They should just be honest and say so, tell us what they want the ERR to be, and detail their plan to reach that goal.  They should also be honest and say that they have worked externally and internally to create an environment where PSPRS will not have to pay PBI's.  I would consider this another breach of fiduciary duty, as well as a veiled form of extortion in which retirees can choose whatever new, lowered PBI formulation that is developed in the next year or subject themselves to the tender mercies of the PSPRS administration and Board of Trustees, who seem intent on doing whatever is in their power to avoid paying PBI's.

After the prepared portion was over their were questions and comments from the audience.  These were from some labor representatives of law enforcement and another man who represented judges.  A lawyer, who I believe is representing PSPRS in the Hall case, also spoke.  During the discussion with the labor representative, it was brought up that there should be some preliminary pension reform ideas coming from the Arizona Legislature around December 17 or 18, 2015.  This appears to be when the study group headed by State Senator Debbie Lesko will release something to build on in the upcoming legislative session.  A present for all of us just in time for the holidays.

The lawyer was asked if he had a timeline for when a final decision in the Hall case will be announced.  He stated that he could not give an exact time, but he expected it to be in late spring or early summer 2016 and that the decision should be faster than a normal Supreme Court case since this is the only case the five judges will have and they understand its urgency.  He stated that this was only the second time that the Arizona Supreme Court has recused itself from a case.  The panel will be made up of two appellate judges and three superior court judges; the two appellate judges were the only two appellate judges in the entire state that were not serving when SB 1609 went into effect and both have criminal law backgrounds.  Arguments before the panel will be made February 18, 2016.

Happy holidays and stay tuned.

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.

2015 Actuarial Valuation Reports by Employer are now available

The 2015 actuarial valuation report for your employer are now available.  PSPRS has upgraded its website, which now allows access to individual employer reports going back to 2009, and uses a drop down menu to choose the employer and report year.  You will need Adobe Acrobat to access the reports.

Worse than it seems: PSPRS' 2015 Actuarial Valuation

The PSPRS Actuarial Valuation as of June 30, 2015 (Fiscal Year 2015) is now available on the PSPRS website.  The actuarial reports for individual employers have not been released, but if you would like to know what your employer's funded ratio is it can be found in Appendix III starting on PDF document page 75.  Your employers contribution rate for the next fiscal year starting July 1, 2016 can be found in Appendix IV starting on PDF document page 81.

Some of the highlights (or lowlights as the case may be) of the report are:

• The aggregate funded ratio dropped from 49.2% to 49.0%.
• The aggregate non-phased-in contribution rate increased from 41.08% to 42.36%.  Employers who chose to pay a lower phased-in rate to help pay the increased costs caused by the Fields case have a lower rate that will be made up in future years.
• PSPRS' total assets increased about $199 million from $6.018 billion to $6.217 billion.
• PSPRS' total liability increased about $453 million $12.233 billion to $12.686 billion.
• PSPRS' total unfunded liability increased about $254 million from $6.229 billion to $6.483 billion.
• The actuary projects the aggregate contribution rate to stay between 42 and 43 percent through 2027, though this is likely to be too low since the actuary used the old 7.85% expected rate of return (ERR) and not the current 7.5% ERR.
• There were 18,409 active, contributing members of PSPRS at the end of FY 2015 versus 18,526 at the end of FY 2014, a decrease of 117.
• There were 11,034 retirees and beneficiaries and 1,675 Deferred Retirement Option Plan (DROP) members for a total of 12,709 non-contributing members of PSPRS at the end of FY 2015.  This is an increase of 626 from the 12,083 (10,524 + 1,559) non-contributing members at the end of FY 2014.  (Depending on when a member entered the DROP, the member may make no contributions to PSPRS while in the program, or the member may continue to contribute to PSPRS while in the program then receive a full refund of the accrued contributions and 2% interest when the member finally leaves work.  Regardless, PSPRS ends  with no employer or employee contributions for the up-to-five years a member is in the DROP.)
• The FY 2015 ratio of active, contributing members to non-contributing members dropped to 1.45.  Last fiscal year the ratio was 1.53.
• The average annual pay for an active, contributing member increased from $75,048 to $76,114.
• The average annual retirement benefit for retirees and beneficiaries increased from $51,616 to $51,833.
• The average annual pay for a member in the DROP increased from $64,173 to $64,659.
• Employers contributed about $448 million to PSPRS in FY 2015 versus about $414 million in FY 2014.
• Employees contributed about $165 million to PSPRS in FY 2015 versus about $152 million in FY 2014.

The decreased funded ratio and increased employer contribution rate speak for themselves, but it is actually worse than it seems.  Even though the funded ratio dropped only 0.2% and the employer contribution rate increased by only 1.28%, we have to remember how PSPRS recognizes its investment gains and losses.  PSPRS uses a seven-year smoothing period to lessen the impact that extraordinarily good or bad years may have on PSPRS' funding ratio and the subsequent calculation of employer contribution rates.  If you are interested in a more detailed explanation of the smoothing period, please see this post.

The Great Recession gave PSPRS two large investment losses in FY 2008 and FY 2009, but these two losses are far enough in the past that they are now beginning to fall out of the seven-year smoothing period.  The FY 2008 smoothed loss of about $119 million was eliminated from the calculation of the FY 2015 funded ratio and replaced by a smaller loss incurred in FY 2015.  This dropped PSPRS' recognized loss over the seven-year period by about $82 million from $282 million to $200 million, and yet, PSPRS' funded ratio continued to drop and the employer contribution rate continued to rise.  This means that liabilities are continuing to grow faster than assets, even as the negative impact of the Great Recession begins to lose some of its effect on PSPRS.

In one of the few years when we could expect to see some improvement in PSPRS finances we instead have another disappointing year.  What do we have to look forward to in the near future?  PSPRS' lowering of its ERR from 7.85% to 7.50% will raise the aggregate employer contribution rate 3%, and a plaintiff victory in the Hall case could raise it another 6% on top of that.  So we could see the aggregate employer rate increase by as much 9% over the next year.  Of course, who knows what is really going to happen next year.  The only certainty is that no matter what happens PSPRS and its Board of Trustees will be there to tell us all how great a job they are doing.