The Arizona Republic has done the best reporting on Arizona's distressed public pensions. This June 23, 2012 article by Craig Harris (Pension funds in Arizona facing bleak future) is such an example. It gives an honest view of the scope and intractability of the problem.
CalPERS, California's massive public employee pension system, earned a miniscule 1% on its investment portfolio for the fiscal year ended June 30, 2012. Mr. Harris' article indicates that PSPRS will likely show disappointing returns also. While PSPRS' consolidated annual financial report (CAFR) will not be released until later this year, PSPRS Administrator Jim Hacking says that for PSPRS, "The picture is not good," and that he believes its funding ratio will drop below 60%.
If you have Labor Day weekend plans, wait until Tuesday to read the article.
Friday, August 31, 2012
Wednesday, August 29, 2012
DROPping the ball
"We have met the enemy, and he is us."
Walt Kelly's comic strip character Pogo
HB2409 was signed into law by Governor Jan Brewer on May 14, 2012. While this bill modified other PSPRS provisions, the most important change involved the Deferred Retirement Option Plan (DROP).
SB1609, passed in 2011, made major changes to the DROP. It eliminated the DROP for anyone hired January 1, 2012 or later. Those with 20 years of service before that date would be still be able to DROP under the provisions in place before SB1609 went into effect. Those hired before January 1, 2012 but without 20 years of service at that date would see a change in how interest is calculated and be required to pay into PSPRS during their time in the DROP.
HB2409 now requires contributions made during a member's time in the DROP to be refunded to the member when the member leaves the DROP. It also requires that a 2% interest rate be paid on those contributions as long as PSPRS earned at least 2% in the prior fiscal year.
The DROP was a short-sighted and irresponsible program from the very beginning, and it worsened the financial condition of PSPRS. SB1609 attempted to remedy some of the problems with the DROP, first by killing it off for future hires, but also by requiring some sacrifice by current members. It should have jettisoned the DROP completely or, at least, required ALL DROP participants who entered after January 1, 2012, regardless of their years of service, to continue making member contributions. Instead, it only affected those with less than 20 years of service as of January 1, 2012. While not ideal, this reform was better than nothing.
Now we see even this minimal reform rolled back. This myopic legislative "victory" is an insult to those yet to be hired, and it represents part of the erosive process that will reverse the necessary changes PSPRS needs to survive.
Walt Kelly's comic strip character Pogo
HB2409 was signed into law by Governor Jan Brewer on May 14, 2012. While this bill modified other PSPRS provisions, the most important change involved the Deferred Retirement Option Plan (DROP).
SB1609, passed in 2011, made major changes to the DROP. It eliminated the DROP for anyone hired January 1, 2012 or later. Those with 20 years of service before that date would be still be able to DROP under the provisions in place before SB1609 went into effect. Those hired before January 1, 2012 but without 20 years of service at that date would see a change in how interest is calculated and be required to pay into PSPRS during their time in the DROP.
HB2409 now requires contributions made during a member's time in the DROP to be refunded to the member when the member leaves the DROP. It also requires that a 2% interest rate be paid on those contributions as long as PSPRS earned at least 2% in the prior fiscal year.
The DROP was a short-sighted and irresponsible program from the very beginning, and it worsened the financial condition of PSPRS. SB1609 attempted to remedy some of the problems with the DROP, first by killing it off for future hires, but also by requiring some sacrifice by current members. It should have jettisoned the DROP completely or, at least, required ALL DROP participants who entered after January 1, 2012, regardless of their years of service, to continue making member contributions. Instead, it only affected those with less than 20 years of service as of January 1, 2012. While not ideal, this reform was better than nothing.
Now we see even this minimal reform rolled back. This myopic legislative "victory" is an insult to those yet to be hired, and it represents part of the erosive process that will reverse the necessary changes PSPRS needs to survive.
The agency problem and public employee pensions
Jack Cross, the administrator of PSPRS from 1983 to 2004, has been accused by current PSPRS officials of improperly increasing his own pension (ABC15 Investigates: Former police and fire pension fund manager accused of inflating his own pension). After an internal audit, Mr. Cross' monthly pension benefit was suspended by officials to recoup an alleged $600,000 in overpayments. Mr. Cross, who draws his pension through the Elected Officials' Retirement Plan, filed a lawsuit in March 2011 to overturn this suspension and alleges that his benefit should have actually been higher. Maricopa County Superior Court records show this case is still ongoing. This shows a classic example of the agency problem.
The agency problem or principal-agent problem describes an inherent dilemma in organizations. In business the dilemma is between the principal, the owner or stockholders, and the agents, the managers. While both parties have general common interests such as keeping the business solvent, each party wants to maximize his gain from participation in the relationship. The agent has multiple interests that includes pay and benefits, power, career advancement, and self-esteem. The principal is primarily interested in maximizing the return on his investment. Stock options, employee stock ownership, and profit-sharing are all ways businesses try to align the interests of principals and agents to minimize the agency problem.
While Mr. Cross' alleged transgression makes a perfect business school case study of the agency problem, its impact on PSPRS' finances is small. The real agency problem for PSPRS and pensions like it involves public employee unions and politicians. Representatives of public employee unions act as agents for their members, both current and future. Politicians are agents for both employees, retirees, and taxpayers. All the principals have an interest in the pension remaining viable for the indefinite future.
However, the self-interest of union representatives and politicians can vary with their principals. Union representatives, who are generally the most senior employees and closest to retirement, will necessarily have an interest in maximizing their own retirement benefits to the detriment of more junior members as well as future hires. Politicians have self-interest in keeping their jobs and will have an incentive to help special interest groups, like public employee unions, who help them stay in office. Taxpayers, who have a huge, long-term financial stake in PSPRS' operation but are unaware of its problems, have their interests ignored by short-sighted politicians who care only about winning the next election.
This also helps answer the question posed in the prior post about why Stockton used bonds to finance enhanced pension benefits.
The agency problem or principal-agent problem describes an inherent dilemma in organizations. In business the dilemma is between the principal, the owner or stockholders, and the agents, the managers. While both parties have general common interests such as keeping the business solvent, each party wants to maximize his gain from participation in the relationship. The agent has multiple interests that includes pay and benefits, power, career advancement, and self-esteem. The principal is primarily interested in maximizing the return on his investment. Stock options, employee stock ownership, and profit-sharing are all ways businesses try to align the interests of principals and agents to minimize the agency problem.
While Mr. Cross' alleged transgression makes a perfect business school case study of the agency problem, its impact on PSPRS' finances is small. The real agency problem for PSPRS and pensions like it involves public employee unions and politicians. Representatives of public employee unions act as agents for their members, both current and future. Politicians are agents for both employees, retirees, and taxpayers. All the principals have an interest in the pension remaining viable for the indefinite future.
However, the self-interest of union representatives and politicians can vary with their principals. Union representatives, who are generally the most senior employees and closest to retirement, will necessarily have an interest in maximizing their own retirement benefits to the detriment of more junior members as well as future hires. Politicians have self-interest in keeping their jobs and will have an incentive to help special interest groups, like public employee unions, who help them stay in office. Taxpayers, who have a huge, long-term financial stake in PSPRS' operation but are unaware of its problems, have their interests ignored by short-sighted politicians who care only about winning the next election.
This also helps answer the question posed in the prior post about why Stockton used bonds to finance enhanced pension benefits.
Monday, August 27, 2012
Moral hazard and public employee pensions
Though the term seems to have popped up just in the last few years, moral hazard has long been a financial and ethical concern in the insurance industry. The "hazard" in moral hazard is that once property is insured, the owner of the insured property has more incentive to risk that property since the financial consequence of property losses are borne by someone else. This is why there are deductibles, co-pays, and co-insurance in insurance policies. By forcing the insured to have some skin in the game, the insurer can mitigate moral hazard, charge reasonable rates, and make a profit.
However, the current use of the term moral hazard and its counterpart "too big too fail" usually refer to financial markets. In a similar vein as insurance moral hazard, large financial firms are more likely to take risks because the government will be there to rescue them if they get in trouble. Because the demise of one large financial firm can affect the entire world economy, those managing those firms may feel that they are, in essence, "insured" by the government. Of course, the government (i.e taxpayers) never agreed to be this insurer of last resort and is paid neither profits from risky ventures nor any underwriting fees.
This brings us to the moral hazard of PSPRS and other public employee pensions. Though PSPRS is a multi-billion dollar fund, its demise would pose no risk to the world economy. The moral hazard in PSPRS comes from legal protections based on both contract law and the Arizona Constitution. Since benefits can never be altered once they are awarded, the incentive will always be for current employees to obtain as many benefits as possible at every opportunity available and never concern themselves with the ultimate risk to PSPRS. When those benefits become financially unsustainable, the taxpayers, primarily, and future hires, secondarily, will be stuck paying the tab as the final "insurers." The members receiving enhanced benefits, the politicians who approved the benefits, and the unions who lobbied for them suffer none of the consequences of this folly.
The question posed in the last post about why Stockton borrowed to fund enhanced pension benefits is partially answered here. And to bring things full circle since this started with a discussion about insurance, read the following New York Times article by Mary Williams Walsh (Creditors of Stockton Fight Pension Funding While in Bankruptcy) to see how moral hazard is being dealt with by actual insurance companies.
However, the current use of the term moral hazard and its counterpart "too big too fail" usually refer to financial markets. In a similar vein as insurance moral hazard, large financial firms are more likely to take risks because the government will be there to rescue them if they get in trouble. Because the demise of one large financial firm can affect the entire world economy, those managing those firms may feel that they are, in essence, "insured" by the government. Of course, the government (i.e taxpayers) never agreed to be this insurer of last resort and is paid neither profits from risky ventures nor any underwriting fees.
This brings us to the moral hazard of PSPRS and other public employee pensions. Though PSPRS is a multi-billion dollar fund, its demise would pose no risk to the world economy. The moral hazard in PSPRS comes from legal protections based on both contract law and the Arizona Constitution. Since benefits can never be altered once they are awarded, the incentive will always be for current employees to obtain as many benefits as possible at every opportunity available and never concern themselves with the ultimate risk to PSPRS. When those benefits become financially unsustainable, the taxpayers, primarily, and future hires, secondarily, will be stuck paying the tab as the final "insurers." The members receiving enhanced benefits, the politicians who approved the benefits, and the unions who lobbied for them suffer none of the consequences of this folly.
The question posed in the last post about why Stockton borrowed to fund enhanced pension benefits is partially answered here. And to bring things full circle since this started with a discussion about insurance, read the following New York Times article by Mary Williams Walsh (Creditors of Stockton Fight Pension Funding While in Bankruptcy) to see how moral hazard is being dealt with by actual insurance companies.
Eat, drink, and be merry for tomorrow our pension may die.
California's bankrupt cities are an easy target for ridicule, and the intention here is not to kick them while they are down. However, this column about the city of Stockton (The State Worker: Are public pensions at risk in bankruptcy?) includes a small bit information that warrants comment.
Jon Ortiz writes that Stockton, "borrowed $125 million from the bond market 5 years ago to pay for a pension benefits hike." This is wrong on so many levels that it is difficult to understand how anyone could even propose something so irresponsible, much less actually implement it.
Bonds are supposed to be an investment. While governments do not invest in the sense that individuals or businesses do because they have no expectation of direct profit, there is an expectation of gain through other means. Better roads, schools, water treatment facilities, etc. are funded with bonds because in the long run the community profits through the betterment of citizen's health and comfort and a more attractive business environment.
Using bonds to fund a benefit increase is borrowing to pay operating expenses. If this were a business, this would be a red flag that the business was having serious problems and may not be a going concern. Of course, a government has a captive customer base and can always bring in more revenue via taxes, but this still leaves open the question of why Stockton would do something so self-destructive to itself and its citizens.
The next posts will attempt to address this question.
Jon Ortiz writes that Stockton, "borrowed $125 million from the bond market 5 years ago to pay for a pension benefits hike." This is wrong on so many levels that it is difficult to understand how anyone could even propose something so irresponsible, much less actually implement it.
Bonds are supposed to be an investment. While governments do not invest in the sense that individuals or businesses do because they have no expectation of direct profit, there is an expectation of gain through other means. Better roads, schools, water treatment facilities, etc. are funded with bonds because in the long run the community profits through the betterment of citizen's health and comfort and a more attractive business environment.
Using bonds to fund a benefit increase is borrowing to pay operating expenses. If this were a business, this would be a red flag that the business was having serious problems and may not be a going concern. Of course, a government has a captive customer base and can always bring in more revenue via taxes, but this still leaves open the question of why Stockton would do something so self-destructive to itself and its citizens.
The next posts will attempt to address this question.
Friday, August 24, 2012
Have a COLA and a smile
Though Arizona SB1609 was signed into law on April 29, 2011, there has already been a successful court challenge to a key provision of the law. The successful challenge (Maricopa judge: Halting pension raises unconstitutional) by retired Arizona judges affects the Elected Officials' Retirement Plan (EORP). EORP is a pension plan pension similar to PSPRS, but its membership is significantly smaller. The judges argued that any change to their cost of living allowances (COLA) violated the Arizona Constitution, which states that "public retirement benefits shall not be diminished or impaired."
Before SB1609, COLA's in both PSPRS and EORP were paid out of a reserve funded by excess returns earned each year. Any year that PSRPS or EORP earned more than 9%, a portion of that excess amount was placed in a Reserve for Future Benefit Increases. As long as funds were available in the Reserve for Future Benefit Increases, a permanent COLA of up to 4% of the average benefit being paid at the end of the prior fiscal year was awarded to retirees.
The problem with this system of awarding COLA's is that it only took into consideration the past year's performance and not the overall health of the pension. A period of negative or substandard returns could cause the funded ratio of PSPRS and EORP to plummet, but when the rate of return again exceeded 9% money would flow into the Reserve for Future Benefit Increases. Instead of all excess returns being used to return the pension to a healthy funded ratio, a portion of the excess was being set aside for COLA's. Retirees were rewarded during good years but shared none of the pain of the bad years. The burden of bringing the pension back to full health was left on the backs of taxpayers and current employees.
SB1609 changed this arrangement by tying COLA's to both annual returns and the funded ratio of the plans as follows:
Forgotten in all this is the pension itself. The task of returning it to fiscal health is only going to get that much harder as these lawsuits chip away at the minimal reforms that SB1609 has already enacted.
Before SB1609, COLA's in both PSPRS and EORP were paid out of a reserve funded by excess returns earned each year. Any year that PSRPS or EORP earned more than 9%, a portion of that excess amount was placed in a Reserve for Future Benefit Increases. As long as funds were available in the Reserve for Future Benefit Increases, a permanent COLA of up to 4% of the average benefit being paid at the end of the prior fiscal year was awarded to retirees.
The problem with this system of awarding COLA's is that it only took into consideration the past year's performance and not the overall health of the pension. A period of negative or substandard returns could cause the funded ratio of PSPRS and EORP to plummet, but when the rate of return again exceeded 9% money would flow into the Reserve for Future Benefit Increases. Instead of all excess returns being used to return the pension to a healthy funded ratio, a portion of the excess was being set aside for COLA's. Retirees were rewarded during good years but shared none of the pain of the bad years. The burden of bringing the pension back to full health was left on the backs of taxpayers and current employees.
SB1609 changed this arrangement by tying COLA's to both annual returns and the funded ratio of the plans 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 prior fiscal 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 prior fiscal 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 survivors.
- 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.
Forgotten in all this is the pension itself. The task of returning it to fiscal health is only going to get that much harder as these lawsuits chip away at the minimal reforms that SB1609 has already enacted.
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