We are still waiting on a decision by the Arizona Supreme Court in the Fields case against the Elected Officials Retirement Plan (EORP). The principal issue in this case, the constitutionality of SB 1609's changes to how cost of living allowances (COLA) are calculated for retirees, is the same as the issue in the Rappleyea case against PSPRS. While the Fields involves retired judges and the Rappleyea case involves retired public safety personnel, the Fields case reached the Supreme Court first and will set the precedent in the Rappleyea case.
Follow this link if you want to see the oral arguments made before the Court on June 4, 2013 and read a summary of the case.
Wednesday, October 16, 2013
Friday, October 4, 2013
Rearranging deck chairs on the Titanic: PSPRS and the bonus controversy
By a unanimous vote of PSPRS' Board of Trustees on September 24, 2013, the payment of bonuses to PSPRS' management and investment staff has been halted until the "next compensation review." This
article by Craig Harris of the Arizona Republic gives more details about the vote and the controversy leading up to it.
PSPRS Adminstrator Jim Hacking had earlier released this forceful response to recent criticism of PSPRS' management, including the payment of bonuses. While Mr. Hacking is certainly the most capable person to defend his staff, there is more to this story that Mr. Hacking, given his apolitical position, is not discussing.
It is important to remember that PSPRS' staff manages the pension according to the laws created by the Arizona legislature and signed by the governor. The PSPRS staff is governed by a seven-member Board of Trustees, serving staggered terms, that is appointed by the governor. The Board of Governors has the ultimate say on how PSPRS' funds are invested. Finally, the PSPRS staff has no input into how employers calculate the benefits of their employees. If one employer allows employees to increase their pensions in an irresponsible way, the PSPRS staff simply figures the employer's unfunded actuarial accrued liability (UAAL) and tells the employer how much it must contribute each year to fund its pension responsibilities. It has no control over that employer's actions.
While it seems fashionable to pile on the PSPRS staff, there is plenty of blame to go around for PSPRS' current woes. Shortsighted and ill-conceived laws and policies created by politicians, lax oversight by past Trustees (or Fund Managers as they used to be called), and pension spiking allowed by employers, of course at the urging of public safety unions, have all contributed to PSPRS underfunding. Mr. Hacking is dealing with multiple issues that preceded his tenure as PSPRS Administrator. PSPRS' funding ratio has been eroding for well over a decade and began long before Mr. Hacking or Ryan Parham, the chief investment officer (CIO) began their current tenures. Yet there is this fixation on bonuses, particularly as they relate to PSPRS' funding ratio and PSPRS' annual return on investment.
The current PSPRS staff is trying to clean up a mess that was created by others. PSPRS' terrible funding ratio shows how big this mess is. The current strategy they are using now is based on diversifying into multiple investment vehicles that try to maximize upside during good times but limit losses during bad times. My understanding is that there are benchmarks for each investment vehicle to determine whether or not the strategy is working, and bonuses are paid based on whether or not these benchmarks are met. This does not mean that PSPRS makes money every year but that it achieves a proper balance between risk and reward that will eventually bring PSPRS back to full funding. This is what the PSPRS staff is being awarded bonuses for, not for a short-term focus on annual gains. The previous post discussed some of the changes Mr. Hacking and Mr. Parham have implemented.
So what of the idea of bonuses in general? It is certainly understandable that taxpayers are uncomfortable with public employees (i.e. public servants) receiving bonuses, but what about union officials, politicians, and public safety personnel? Those that lobbied for, created, and have participated in or plan to participate in the Deferred Retirement Option Plan (DROP) have no right to complain about bonuses since, after all, the DROP is nothing but a giant bonus program to public safety personnel. This Arizona Republic database shows how big some of these bonuses are, with the average DROP payment reaching into five and six figures, depending on the employer. Do these DROP payments perform any real purpose other than to enrich retiring public safety personnel? No, and for those who disagree, see the series of posts entitled "The Folly of the DROP" here, here, and here.
So those that wanted to end the bonuses got their way, and an agreement for a promised payment was broken. In the end, everyone would be well advised to reread Mr. Hacking's response, particularly the part about pending lawsuits against PSPRS. If you think bonuses are a problem, wait until you see what the Arizona Supreme Court does to PSPRS' funding ratio after it rules on these lawsuits.
article by Craig Harris of the Arizona Republic gives more details about the vote and the controversy leading up to it.
PSPRS Adminstrator Jim Hacking had earlier released this forceful response to recent criticism of PSPRS' management, including the payment of bonuses. While Mr. Hacking is certainly the most capable person to defend his staff, there is more to this story that Mr. Hacking, given his apolitical position, is not discussing.
It is important to remember that PSPRS' staff manages the pension according to the laws created by the Arizona legislature and signed by the governor. The PSPRS staff is governed by a seven-member Board of Trustees, serving staggered terms, that is appointed by the governor. The Board of Governors has the ultimate say on how PSPRS' funds are invested. Finally, the PSPRS staff has no input into how employers calculate the benefits of their employees. If one employer allows employees to increase their pensions in an irresponsible way, the PSPRS staff simply figures the employer's unfunded actuarial accrued liability (UAAL) and tells the employer how much it must contribute each year to fund its pension responsibilities. It has no control over that employer's actions.
While it seems fashionable to pile on the PSPRS staff, there is plenty of blame to go around for PSPRS' current woes. Shortsighted and ill-conceived laws and policies created by politicians, lax oversight by past Trustees (or Fund Managers as they used to be called), and pension spiking allowed by employers, of course at the urging of public safety unions, have all contributed to PSPRS underfunding. Mr. Hacking is dealing with multiple issues that preceded his tenure as PSPRS Administrator. PSPRS' funding ratio has been eroding for well over a decade and began long before Mr. Hacking or Ryan Parham, the chief investment officer (CIO) began their current tenures. Yet there is this fixation on bonuses, particularly as they relate to PSPRS' funding ratio and PSPRS' annual return on investment.
The current PSPRS staff is trying to clean up a mess that was created by others. PSPRS' terrible funding ratio shows how big this mess is. The current strategy they are using now is based on diversifying into multiple investment vehicles that try to maximize upside during good times but limit losses during bad times. My understanding is that there are benchmarks for each investment vehicle to determine whether or not the strategy is working, and bonuses are paid based on whether or not these benchmarks are met. This does not mean that PSPRS makes money every year but that it achieves a proper balance between risk and reward that will eventually bring PSPRS back to full funding. This is what the PSPRS staff is being awarded bonuses for, not for a short-term focus on annual gains. The previous post discussed some of the changes Mr. Hacking and Mr. Parham have implemented.
So what of the idea of bonuses in general? It is certainly understandable that taxpayers are uncomfortable with public employees (i.e. public servants) receiving bonuses, but what about union officials, politicians, and public safety personnel? Those that lobbied for, created, and have participated in or plan to participate in the Deferred Retirement Option Plan (DROP) have no right to complain about bonuses since, after all, the DROP is nothing but a giant bonus program to public safety personnel. This Arizona Republic database shows how big some of these bonuses are, with the average DROP payment reaching into five and six figures, depending on the employer. Do these DROP payments perform any real purpose other than to enrich retiring public safety personnel? No, and for those who disagree, see the series of posts entitled "The Folly of the DROP" here, here, and here.
So those that wanted to end the bonuses got their way, and an agreement for a promised payment was broken. In the end, everyone would be well advised to reread Mr. Hacking's response, particularly the part about pending lawsuits against PSPRS. If you think bonuses are a problem, wait until you see what the Arizona Supreme Court does to PSPRS' funding ratio after it rules on these lawsuits.
Wednesday, August 28, 2013
Why PSPRS is paying out bonuses
PSPRS released this memo by Administrator Jim Hacking on August 16, 2013 in response to this August 11, 2013 Arizona Republic story, Arizona pension system gave out bonuses, by Craig Harris. While Mr. Hacking is certainly more qualified than me to defend the bonus structure of PSPRS, I believe that some more explanation is needed.
Mr. Hacking brings up two important points in his memo. The first is that PSPRS is competing for talent with other non-profits and the private sector. This 2011 chart from Pensions & Investments lists the 50 top paid chief investment officers (CIO) of US tax-exempt organizations. The list includes colleges and universities, charitable foundations, and pension systems. The list was topped by the CIO of Harvard University's endowment. In 2011, she managed an endowment of $27.6 billion and was paid $4.75 million. Number 50 managed the Rockefeller Foundation's $3.8 billion and was paid about $590,000. The Republic article lists PSPRS CIO Ryan Parham's current base salary as $254,000, which will increase automatically to $268,000 on September 20, 2013, He will also be eligible for a $75,000 retention bonus a year after that if he remains as PSPRS CIO. The combined assets of PSPRS, CORP, and EORP, which are administered together as one investment pool, equaled approximately $6.7 billion on June 30, 2012.
The list of the 50 top paid CIO's contained only two who managed pension systems, one who earned about $1 million managing Texas' $100 billion teachers retirement system and another who earned $608,000 managing Georgia's $46 billion teachers retirement system. I do not know the average salary for the CIO of a public pension CIO nor do I know how to assess the quality of one CIO versus another. However, just looking at his overall compensation, it seems that Mr. Parham's salary is not out of line. The Republic article focused on bonuses, which makes readers understandably angry when they consider the underfunded status of PSPRS. However, this brings us to the second important point in Mr. Hacking's memo.
Mr. Hacking just briefly touches on this point by highlighting the gains made with the implementation of a new investment strategy. This is actually a much more crucial point, which he may not be giving the proper emphasis due to his apolitical position as PSPRS Administrator. Since I do not have that problem, I can provide a little more history.
Below is a breakdown of PSPRS' investments as of June 30, 2008, just prior to the start of the Great Recession:
US Government Securities 13.50%
Corporate Bonds 12.20%
Total Fixed Income 25.70%
Common Stock 67.79%
Alternative Investments 6.51%
Contrast this with the investment breakdown as of June 30,2012:
US Equity 19.71%
Non-US Equity 14.45%
Total Equity (Common Stock) 34.16%
Fixed Income 13.86%
Global Tactical Asset Allocation (GTAA) 9.68%
Credit Opportunities 8.83%
Real Assets 6.39%
Private Equity 10.45%
Absolute Return 3.56%
Real Estate 13.07%
Total Alternative Investments 51.98%
As can be seen, there has been a dramatic change in the investment strategy of PSPRS. This coincides with Mr. Parham's promotion into the CIO position. He was listed as interim CIO in fiscal year 2007 and 2008 reports, and he is listed as permanent CIO in the fiscal year 2009 report.
The initial asset allocation appears not much different than that of an individual investor with a split between stocks and bonds. This is a legacy of the past investment strategy. If we go back to June 30, 2000 before the dot.com crash, PSPRS' allocation was 77.61% common stock and 19.15% bonds, a nearly complete commitment to stocks and bonds. This had been a successful for many years until the two market crashes last decade showed the folly of this strategy.
Looking even deeper into the investments PSPRS held on June 30, 2008, we can see the top five equity investments were in financial companies: Citigroup, Bank of America, National City Corporation, Washington Mutual, and Wachovia, representing over $425 million in investments. National City, Washington Mutual, and Wachovia were all taken over by other financial companies with huge losses to shareholders. According to PSPRS' 2009 report, the losses on these three companies alone were approximately $110 million.
Obviously, a huge portfolio like PSPRS' is bound to have some losers amongst it, but the real problem here was the over-concentration of PSPRS' portfolio in equities. This was the same problem after the dot.com crash. Some have tried to lay the blame for those losses on former PSPRS Administrator Jack Cross, while conveniently forgetting the huge returns he produced for years using the same equity-heavy strategy. Now the current bonus controversy is being used against Mr. Parham, and to a lesser extent, against Mr. Hacking.
The only criticism that could be leveled against Mr. Parham was that he did not change the balance of PSPRS' portfolio before the last market crash. I do not know how aware he or Mr. Hacking were of PSPRS' perilous state in 2007 or 2008 or what their plan for PSPRS was at that time, but to expect some special prescience about the imminent market crash is absurd. I do not know if it was even possible to rebalance the portfolio in time. I suspect a process like this takes months, if not years, to accomplish as it entails consultation with advisors and buying and selling investments in an orderly fashion.
In the end, Mr. Parham's job has been to clean up a mess that was there when he took over as CIO. It appears from the outside that no one responsible for PSPRS realized what the real problem was. The dot.com debacle was followed by the same pattern of equity investment, I guess, with the idea that the previous losses would be more than made up in the next boom. We all know how wrong that was. Only now is an investment philosophy being put in place that recognizes that PSPRS can not just play the boom and bust cycle of the market. PSPRS must try to maximize gains but not at the expense of losing capital. That is what Mr. Parham is trying to do with the new asset allocation (For more information see this Institutional Investor article).
Those who are upset about bonuses need to understand that we will not see the real value of Mr. Parham's wisdom until another market crash. Based on PSPRS' own amortization schedule, it will take years for PSPRS to reach full funding again, so to expect a bonus structure based on PSPRS' funding level is not realistic. However, if Mr. Parham's strategy keeps PSPRS from being devastated again during the next crisis, he will have been worth every penny it took to retain him. Of course, only time will tell how it works, but we do know the old strategy was a disaster. It would be a shame if Mr. Parham was driven out by a penny-wise, pound-foolish lynch mob.
Mr. Hacking brings up two important points in his memo. The first is that PSPRS is competing for talent with other non-profits and the private sector. This 2011 chart from Pensions & Investments lists the 50 top paid chief investment officers (CIO) of US tax-exempt organizations. The list includes colleges and universities, charitable foundations, and pension systems. The list was topped by the CIO of Harvard University's endowment. In 2011, she managed an endowment of $27.6 billion and was paid $4.75 million. Number 50 managed the Rockefeller Foundation's $3.8 billion and was paid about $590,000. The Republic article lists PSPRS CIO Ryan Parham's current base salary as $254,000, which will increase automatically to $268,000 on September 20, 2013, He will also be eligible for a $75,000 retention bonus a year after that if he remains as PSPRS CIO. The combined assets of PSPRS, CORP, and EORP, which are administered together as one investment pool, equaled approximately $6.7 billion on June 30, 2012.
The list of the 50 top paid CIO's contained only two who managed pension systems, one who earned about $1 million managing Texas' $100 billion teachers retirement system and another who earned $608,000 managing Georgia's $46 billion teachers retirement system. I do not know the average salary for the CIO of a public pension CIO nor do I know how to assess the quality of one CIO versus another. However, just looking at his overall compensation, it seems that Mr. Parham's salary is not out of line. The Republic article focused on bonuses, which makes readers understandably angry when they consider the underfunded status of PSPRS. However, this brings us to the second important point in Mr. Hacking's memo.
Mr. Hacking just briefly touches on this point by highlighting the gains made with the implementation of a new investment strategy. This is actually a much more crucial point, which he may not be giving the proper emphasis due to his apolitical position as PSPRS Administrator. Since I do not have that problem, I can provide a little more history.
Below is a breakdown of PSPRS' investments as of June 30, 2008, just prior to the start of the Great Recession:
US Government Securities 13.50%
Corporate Bonds 12.20%
Total Fixed Income 25.70%
Common Stock 67.79%
Alternative Investments 6.51%
Contrast this with the investment breakdown as of June 30,2012:
US Equity 19.71%
Non-US Equity 14.45%
Total Equity (Common Stock) 34.16%
Fixed Income 13.86%
Global Tactical Asset Allocation (GTAA) 9.68%
Credit Opportunities 8.83%
Real Assets 6.39%
Private Equity 10.45%
Absolute Return 3.56%
Real Estate 13.07%
Total Alternative Investments 51.98%
As can be seen, there has been a dramatic change in the investment strategy of PSPRS. This coincides with Mr. Parham's promotion into the CIO position. He was listed as interim CIO in fiscal year 2007 and 2008 reports, and he is listed as permanent CIO in the fiscal year 2009 report.
The initial asset allocation appears not much different than that of an individual investor with a split between stocks and bonds. This is a legacy of the past investment strategy. If we go back to June 30, 2000 before the dot.com crash, PSPRS' allocation was 77.61% common stock and 19.15% bonds, a nearly complete commitment to stocks and bonds. This had been a successful for many years until the two market crashes last decade showed the folly of this strategy.
Looking even deeper into the investments PSPRS held on June 30, 2008, we can see the top five equity investments were in financial companies: Citigroup, Bank of America, National City Corporation, Washington Mutual, and Wachovia, representing over $425 million in investments. National City, Washington Mutual, and Wachovia were all taken over by other financial companies with huge losses to shareholders. According to PSPRS' 2009 report, the losses on these three companies alone were approximately $110 million.
Obviously, a huge portfolio like PSPRS' is bound to have some losers amongst it, but the real problem here was the over-concentration of PSPRS' portfolio in equities. This was the same problem after the dot.com crash. Some have tried to lay the blame for those losses on former PSPRS Administrator Jack Cross, while conveniently forgetting the huge returns he produced for years using the same equity-heavy strategy. Now the current bonus controversy is being used against Mr. Parham, and to a lesser extent, against Mr. Hacking.
The only criticism that could be leveled against Mr. Parham was that he did not change the balance of PSPRS' portfolio before the last market crash. I do not know how aware he or Mr. Hacking were of PSPRS' perilous state in 2007 or 2008 or what their plan for PSPRS was at that time, but to expect some special prescience about the imminent market crash is absurd. I do not know if it was even possible to rebalance the portfolio in time. I suspect a process like this takes months, if not years, to accomplish as it entails consultation with advisors and buying and selling investments in an orderly fashion.
In the end, Mr. Parham's job has been to clean up a mess that was there when he took over as CIO. It appears from the outside that no one responsible for PSPRS realized what the real problem was. The dot.com debacle was followed by the same pattern of equity investment, I guess, with the idea that the previous losses would be more than made up in the next boom. We all know how wrong that was. Only now is an investment philosophy being put in place that recognizes that PSPRS can not just play the boom and bust cycle of the market. PSPRS must try to maximize gains but not at the expense of losing capital. That is what Mr. Parham is trying to do with the new asset allocation (For more information see this Institutional Investor article).
Those who are upset about bonuses need to understand that we will not see the real value of Mr. Parham's wisdom until another market crash. Based on PSPRS' own amortization schedule, it will take years for PSPRS to reach full funding again, so to expect a bonus structure based on PSPRS' funding level is not realistic. However, if Mr. Parham's strategy keeps PSPRS from being devastated again during the next crisis, he will have been worth every penny it took to retain him. Of course, only time will tell how it works, but we do know the old strategy was a disaster. It would be a shame if Mr. Parham was driven out by a penny-wise, pound-foolish lynch mob.
Saturday, August 24, 2013
PSPRS and pension spiking, part III
So did someone say something about spiking? This video about the highest-paid employees in Tucson city government comes from KVOA, the NBC affiliate in Tucson:
The video is accompanied by this story, which includes a list that shows the compensation of Tucson's top-paid employees. The list breaks down compensation between base pay and other pay and benefits. For public safety personnel, who make up more than half of the top 100, overtime and sick leave sell back make up significant portions of their compensation. A searchable and more user-friendly list from 2011 is available here from the Arizona Daily Star.
KVOA's report does not mention retirement or pension spiking. However, it does include the current mayor and a former mayor discussing the practice of sick leave sellback. Current Mayor Jonathan Rothschild says sick leave sellback is something the Mayor and Council are "going to look at this year," and former Mayor Tom Volgy even refers to it as "a lousy practice." It makes one wonder how they feel about using sick leave sellback in pension calculations.
When SB 1609 was enacted in 2011, one of the provisions of the law was the creation of a study committee on Arizona's retirement systems. The Defined Contribution & Retirement Study Committee Final Report is the end product of that committee. It includes information and recommendations on five issues that the committee was tasked to study. One of those issues was pension spiking.
The committee used the following criteria to define pension spiking in PSPRS: a "more than 25% increase in compensation during the final 36 months of employment in PSPRS." This threshold is "more than twice the average compensation increase that the plan uses in determining wage inflation in the final years of employment." The years they used for comparison, 2008-2011, followed immediately after the housing market crash, so it is unlikely that there was any actual wage inflation anywhere in Arizona. This makes any compensation increases in those years all the more dramatic.
The study found that in 2008 25.16% of retirees had an increase in compensation of more than 25% in their final three years. In 2009, it was 29.77%, 2010-27.27%, and 2011-22.60%. This means that in those four years 20-30% of all retirees were able to increase their final compensation by more than 25%. In the previous post, we used only a 10% increase for our hypothetical retiree. If she had increased her final compensation by 25%, she would have increased her annual pension by $10,937, instead of $4,375. From 2008 to 2011 this type of spiking was being done by 2-3 out of every 10 PSPRS retirees. This is not insignificant and was far greater than I would have imagined.
I suspect that it was also far greater than the committee imagined. Their recommendations read:
However, implementing this type of change to current workers may be problematic. Workers with 10, 15, or 20 years of service, who have been paying pension contributions over the year on thousands of dollars of non-base pay compensation, would be due refunds with interest on all those accumulated pension contributions. This says nothing of what refunds their employers might also be due. PSPRS can not expect contributions to be paid on income that is not included in final pension calculations.
I fear that any "reform" to pension spiking will only affect new hires and will be another case of the current generation passing costs on to the next generation of police and firefighters. Hopefully, the legislature will devise a solution that involves shared sacrifice this time around.
Of course, the Tucson City Council may have one pontential solution to salary and pension spiking in mind that was hinted at in the video. They can simply eliminate sick leave sellback completely if they believe its elimination would more than offset the overtime costs incurred with any increased sick leave use. While it is easy to demonize the Goldwater Institute for their lawsuit, it is clear that they are not the only ones who see a problem with pension spiking.
The video is accompanied by this story, which includes a list that shows the compensation of Tucson's top-paid employees. The list breaks down compensation between base pay and other pay and benefits. For public safety personnel, who make up more than half of the top 100, overtime and sick leave sell back make up significant portions of their compensation. A searchable and more user-friendly list from 2011 is available here from the Arizona Daily Star.
KVOA's report does not mention retirement or pension spiking. However, it does include the current mayor and a former mayor discussing the practice of sick leave sellback. Current Mayor Jonathan Rothschild says sick leave sellback is something the Mayor and Council are "going to look at this year," and former Mayor Tom Volgy even refers to it as "a lousy practice." It makes one wonder how they feel about using sick leave sellback in pension calculations.
When SB 1609 was enacted in 2011, one of the provisions of the law was the creation of a study committee on Arizona's retirement systems. The Defined Contribution & Retirement Study Committee Final Report is the end product of that committee. It includes information and recommendations on five issues that the committee was tasked to study. One of those issues was pension spiking.
The committee used the following criteria to define pension spiking in PSPRS: a "more than 25% increase in compensation during the final 36 months of employment in PSPRS." This threshold is "more than twice the average compensation increase that the plan uses in determining wage inflation in the final years of employment." The years they used for comparison, 2008-2011, followed immediately after the housing market crash, so it is unlikely that there was any actual wage inflation anywhere in Arizona. This makes any compensation increases in those years all the more dramatic.
The study found that in 2008 25.16% of retirees had an increase in compensation of more than 25% in their final three years. In 2009, it was 29.77%, 2010-27.27%, and 2011-22.60%. This means that in those four years 20-30% of all retirees were able to increase their final compensation by more than 25%. In the previous post, we used only a 10% increase for our hypothetical retiree. If she had increased her final compensation by 25%, she would have increased her annual pension by $10,937, instead of $4,375. From 2008 to 2011 this type of spiking was being done by 2-3 out of every 10 PSPRS retirees. This is not insignificant and was far greater than I would have imagined.
I suspect that it was also far greater than the committee imagined. Their recommendations read:
- Legislation should be considered going forward that limits retirement benefits to base salary compensation and does not include off-duty work and the use of lump sum payouts at termination of vacation and sick time. This would mitigate some of the methods in which a salary can be "spiked" to boost retirement benefits. (italics mine)
- Further legislative study of spiking and other methods of increasing compensation that affect final retirement benefits should be conducted.
However, implementing this type of change to current workers may be problematic. Workers with 10, 15, or 20 years of service, who have been paying pension contributions over the year on thousands of dollars of non-base pay compensation, would be due refunds with interest on all those accumulated pension contributions. This says nothing of what refunds their employers might also be due. PSPRS can not expect contributions to be paid on income that is not included in final pension calculations.
I fear that any "reform" to pension spiking will only affect new hires and will be another case of the current generation passing costs on to the next generation of police and firefighters. Hopefully, the legislature will devise a solution that involves shared sacrifice this time around.
Of course, the Tucson City Council may have one pontential solution to salary and pension spiking in mind that was hinted at in the video. They can simply eliminate sick leave sellback completely if they believe its elimination would more than offset the overtime costs incurred with any increased sick leave use. While it is easy to demonize the Goldwater Institute for their lawsuit, it is clear that they are not the only ones who see a problem with pension spiking.
Thursday, August 22, 2013
PSPRS and pension spiking, part II
The type of pension spiking that is occurring in Phoenix, which appears to be in clear violation of state law since it uses lump sum payouts in final pension calculations, is not the only type of pension spiking that impacts PSPRS. The more common type of pension spiking occurs when a worker uses other methods to increase the final average salary used to calculate his pension benefit.
For all workers hired before January 1, 2012, the final pension benefit is calculated based on the average of their high three-year salary period. (For those hired on January 1, 2012 or later, the calculation is based on the high five-year period.) This means that a worker interested in maximizing his pension can utilize pay enhancements like overtime and incremental sick leave sellback programs to increase his average salary. These types of enhancements appear to fit within state law as they do not involve lump sum payments. Workers are free to work overtime as needed by their employer, and incremental sick leave sellback programs allow workers to sell back portions of their accrued sick leave while they are still working. This means regular payments are made during a participant's career, not as a lump sum payments at the end of his career.
So what effect does this type of pension spiking have on PSPRS' finances? Using the same type of example as in the previous post, we can use a Tucson Fire Department (TFD) member who retires or DROP's after 25 years and will have a final pension benefit calculated at 62.5% (a 2.5% pension multiplier for each year of service) of the average of her high 3-year salary period. If through a combination of selling back sick leave and working overtime she is able to increase her average annual salary of $70,000 by 10%, she will earn an extra $7,000 per year. This would translate to an increase in her annual pension benefit of $4,375. If she lives another 20 years she will reap an extra $87,500 in benefits.
If we use the current combined contribution rate for TFD of 57.12% (10.35% employee and 46.77% employer), each year PSPRS would receive approximately $3,998 in additional contributions. If this amount was paid into PSPRS on a biweekly basis this would equal approximately $154 every two weeks. This steady $154 paid every two weeks, compounded daily at 8% annual interest, would grow to $13,597 after three years. This $13,597 compounding at the same interest rate would increase to $67,335 after another 20 years. This means that 20 years into this member's retirement PSPRS would actually see a deficit of $20,165.
Using different interest rates we can see where the breakeven point for PSPRS is when it comes to spiking:
Interest Rate Balance at 20 Years Gain or (Loss)
6.00% $43,742 ($43,758)
7.00% $54,267 ($33,233)
7.85% $65,191 ($22,309)
8.00% $67,335 ($20,165)
9.00% $83,551 ($3,949)
9.25% $94,794 $684
10.00% $113,869 $16,177
PSPRS does not break even in this case of pension spiking until the interest rate reaches around 9.25%. 7.85% rate is PSPRS' expected rate of return (ERR) for the current fiscal year. So while this case of pension spiking may not appear as bad that occurs when lump sum payments are used, it still takes a toll on PSPRS' finances to the tune of $22,000 at the current ERR. It is also very important to remember that of the additional $3,998 paid each year into PSPRS, the employee paid only about $725, the taxpayers picked up the other $3,273. All in all, the employee paid an extra $2,175 to receive an additional $87,500 in benefits over 20 years.
These numbers are projected out from simple estimates, but it again shows how pension spiking blunts the power of compounding. TFD's high contribution rate tells us that they are already badly underfunded, so a pension spike like this only makes their situation worse. For anyone interested in running numbers, Bankrate has this compound interest calculator that I used for computations.
While this case may not be as egregious as those in Phoenix, it is still harmful. This case would be much worse if Tucson taxpayers were not already paying such a high contribution rate. While an individual case may not seem so bad, when combined with thousands of others, you start to see the problem. If you think this problem has not been noticed by those able to change the law, you would be wrong. More on that in the next post.
For all workers hired before January 1, 2012, the final pension benefit is calculated based on the average of their high three-year salary period. (For those hired on January 1, 2012 or later, the calculation is based on the high five-year period.) This means that a worker interested in maximizing his pension can utilize pay enhancements like overtime and incremental sick leave sellback programs to increase his average salary. These types of enhancements appear to fit within state law as they do not involve lump sum payments. Workers are free to work overtime as needed by their employer, and incremental sick leave sellback programs allow workers to sell back portions of their accrued sick leave while they are still working. This means regular payments are made during a participant's career, not as a lump sum payments at the end of his career.
So what effect does this type of pension spiking have on PSPRS' finances? Using the same type of example as in the previous post, we can use a Tucson Fire Department (TFD) member who retires or DROP's after 25 years and will have a final pension benefit calculated at 62.5% (a 2.5% pension multiplier for each year of service) of the average of her high 3-year salary period. If through a combination of selling back sick leave and working overtime she is able to increase her average annual salary of $70,000 by 10%, she will earn an extra $7,000 per year. This would translate to an increase in her annual pension benefit of $4,375. If she lives another 20 years she will reap an extra $87,500 in benefits.
If we use the current combined contribution rate for TFD of 57.12% (10.35% employee and 46.77% employer), each year PSPRS would receive approximately $3,998 in additional contributions. If this amount was paid into PSPRS on a biweekly basis this would equal approximately $154 every two weeks. This steady $154 paid every two weeks, compounded daily at 8% annual interest, would grow to $13,597 after three years. This $13,597 compounding at the same interest rate would increase to $67,335 after another 20 years. This means that 20 years into this member's retirement PSPRS would actually see a deficit of $20,165.
Using different interest rates we can see where the breakeven point for PSPRS is when it comes to spiking:
Interest Rate Balance at 20 Years Gain or (Loss)
6.00% $43,742 ($43,758)
7.00% $54,267 ($33,233)
7.85% $65,191 ($22,309)
8.00% $67,335 ($20,165)
9.00% $83,551 ($3,949)
9.25% $94,794 $684
10.00% $113,869 $16,177
PSPRS does not break even in this case of pension spiking until the interest rate reaches around 9.25%. 7.85% rate is PSPRS' expected rate of return (ERR) for the current fiscal year. So while this case of pension spiking may not appear as bad that occurs when lump sum payments are used, it still takes a toll on PSPRS' finances to the tune of $22,000 at the current ERR. It is also very important to remember that of the additional $3,998 paid each year into PSPRS, the employee paid only about $725, the taxpayers picked up the other $3,273. All in all, the employee paid an extra $2,175 to receive an additional $87,500 in benefits over 20 years.
These numbers are projected out from simple estimates, but it again shows how pension spiking blunts the power of compounding. TFD's high contribution rate tells us that they are already badly underfunded, so a pension spike like this only makes their situation worse. For anyone interested in running numbers, Bankrate has this compound interest calculator that I used for computations.
While this case may not be as egregious as those in Phoenix, it is still harmful. This case would be much worse if Tucson taxpayers were not already paying such a high contribution rate. While an individual case may not seem so bad, when combined with thousands of others, you start to see the problem. If you think this problem has not been noticed by those able to change the law, you would be wrong. More on that in the next post.
Monday, August 19, 2013
PSPRS and pension spiking, part I
The Goldwater Institute, the bête noire of Arizona's public employee unions, has filed a lawsuit to end the practice of pension "spiking" by Phoenix police and firefighters. This August 15, 2013 article by Craig Harris in the Arizona Republic details the principal issue of the case, the use of lump sum payouts for unused vacation, sick time, and other deferred compensation to increase (spike) the final retirement benefits of police and firefighters.
The article makes a pretty unimpeachable case that this violates state law. The relevant Arizona statute reads:
The heart of the issue here is, as always, financial. Pension spiking bleeds PSPRS and soaks taxpayers because it robs the pension of its most important tool to stay solvent--compounding over time. A pension contribution at the end of a career raises the final benefit though the contribution did not grow over time. For example, someone retiring from the Phoenix Fire Department (PFD) today who sold back $30,000 in unpaid time would pay an employee contribution (currently 10.35%) of $3,105 and the city of Phoenix would make an employer contribution (currently 34.95%) of $10,850. If this individual retired at 25 years, he would raise his average three-year high salary by $10,000 per year and boost his pension by $6,250 per year for the rest of his life. If the combined contributions of $13,955 were to compound daily at 8% annual interest, it would increase to $69,108 after 20 years. The individual would be paid an extra $125,000 pension benefit over those 20 years. This would leave a deficit to the pension of $55,892. This shortfall would need to be made up by taxpayers over the years.
Contrast this financial example with one where the $13,955 had been contributed over the 25 years of his career. This would translate to approximately $21 biweekly over 25 years. At 8% annual interest, compounded daily, this steady biweekly contribution of $21 would equal $43,667 after 25 years. If this $43,667 continued to earn the same 8% interest rate, 20 years later it would be worth $216,246. This would be more than sufficient to cover the spike in the retiree's pension that he received from selling back his unused time.
These calculations, of course, do not take into consideration the changes in either contribution rates or rates of return on the PSPRS' investments. It is only meant to show how damaging end-of-career pension spiking is. Even a retiree who believes he earned his spiked pension benefits because of all the family and leisure time he gave up while employed must acknowledge that this is not sustainable over the long-term. Nor is it fair to Phoenix taxpayers who must foot the ultimate bill for the extra costs of spiking. They already pay for a very good retirement for their public safety workers.
While this lawsuit may appear to affect only those PSPRS members who work for the city of Phoenix, there is more to the story of pension spiking, and it affects all PSPRS members. The next post will cover this issue further.
The article makes a pretty unimpeachable case that this violates state law. The relevant Arizona statute reads:
"Compensation" means, for the purpose of computing retirement benefits, base salary, overtime pay, shift differential pay, military differential wage pay, compensatory time used by an employee in lieu of overtime not otherwise paid by an employer and holiday pay paid to an employee by the employer on a regular monthly, semimonthly or biweekly payroll basis and longevity pay paid to an employee at least every six months for which contributions are made to the system pursuant to section 38-843, subsection D. Compensation does not include, for the purpose of computing retirement benefits, payment for unused sick leave, payment in lieu of vacation, payment for unused compensatory time or payment for any fringe benefits. (Italics mine)While it is fair that employees be compensated for unused time after they leave employment, the Phoenix public safety unions and city officials give no justification as to why this time should be included in pension calculations, especially when it is expressly forbidden. Nor do they explain how pension spiking benefits Phoenix's taxpayers, who pay city taxes on both rent and food. The usual arguments about pay and benefits revolve around how they are necessary for retention of good employees. However, this benefit is being paid to individuals who are leaving city employment forever. The city and union officials have only made a weak statement about this being a legal, negotiated item that can not be changed until the next round of contract negotiations. This is a ridiculous defense since a contract can not supersede state law. After the last few years of conflict with the federal government over several state laws, all Arizonans are probably well-versed on the legal concept of supremacy.
The heart of the issue here is, as always, financial. Pension spiking bleeds PSPRS and soaks taxpayers because it robs the pension of its most important tool to stay solvent--compounding over time. A pension contribution at the end of a career raises the final benefit though the contribution did not grow over time. For example, someone retiring from the Phoenix Fire Department (PFD) today who sold back $30,000 in unpaid time would pay an employee contribution (currently 10.35%) of $3,105 and the city of Phoenix would make an employer contribution (currently 34.95%) of $10,850. If this individual retired at 25 years, he would raise his average three-year high salary by $10,000 per year and boost his pension by $6,250 per year for the rest of his life. If the combined contributions of $13,955 were to compound daily at 8% annual interest, it would increase to $69,108 after 20 years. The individual would be paid an extra $125,000 pension benefit over those 20 years. This would leave a deficit to the pension of $55,892. This shortfall would need to be made up by taxpayers over the years.
Contrast this financial example with one where the $13,955 had been contributed over the 25 years of his career. This would translate to approximately $21 biweekly over 25 years. At 8% annual interest, compounded daily, this steady biweekly contribution of $21 would equal $43,667 after 25 years. If this $43,667 continued to earn the same 8% interest rate, 20 years later it would be worth $216,246. This would be more than sufficient to cover the spike in the retiree's pension that he received from selling back his unused time.
These calculations, of course, do not take into consideration the changes in either contribution rates or rates of return on the PSPRS' investments. It is only meant to show how damaging end-of-career pension spiking is. Even a retiree who believes he earned his spiked pension benefits because of all the family and leisure time he gave up while employed must acknowledge that this is not sustainable over the long-term. Nor is it fair to Phoenix taxpayers who must foot the ultimate bill for the extra costs of spiking. They already pay for a very good retirement for their public safety workers.
While this lawsuit may appear to affect only those PSPRS members who work for the city of Phoenix, there is more to the story of pension spiking, and it affects all PSPRS members. The next post will cover this issue further.
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