Phoenix Pension Reform Act Summary Analysis

This November taxpayers will be asked to vote on whether or not to approve the Phoenix Pension Reform Act. The ballot initiative would recalculate benefits for current public employees, primarily by ending a troublesome practice known as pension “spiking,” and put future government workers in 401(k)-style retirement accounts instead of the current defined benefit pensions. The Act would also end the practice of allowing public sector workers to dual enroll in a second, City operated retirement plan.

The initiative represents a concrete idea in what has otherwise been a vague discussion about how to address the $1.5 billion in unfunded liabilities and pending recruitment troubles Phoenix faces. The question, however, is whether the proposed Act would ultimately benefit taxpayers or not.

The City’s actuary, Cheiron, recently analyzed the Pension Reform Act and found that it would cost taxpayers $564 million over 20 years, assuming a 6 percent contribution rate to the new defined-contribution accounts. That would appear to be a vote against the plan, but a closer look shows they admittedly did not account for the three components of the Pension Reform Act that would produce substantial savings.

Reason Foundation’s analysis of the Phoenix Pension Reform Act finds it would actually save taxpayers $31 million in the first year of reform, and ultimately reduce pension costs by $399.3 million over the next 20 years compared to the status quo.

This projected savings stems from permanently ending pension spiking, changing the pension calculation so that workers’ pensions are based on their last five years of salary instead of their final three years, and preventing government workers who are in the pension plan from enrolling in a secondary, deferred compensation retirement plan as well.

Our savings figure assumes a 7 percent defined-contribution rate, though if City defines the rate lower then taxpayers will save even more (as shown in the below table).

The Recruitment Challenge in the Status Quo

Beyond the measurable savings, we also find that the Pension Reform Act will help stave off a recruitment nightmare for Phoenix.

A 2012 pension reform known as “Prop 201” requires new public sector employees to split pension-funding costs 50/50 with Phoenix taxpayers. While a good deal for taxpayers on its face, this is going to translate into public sector workers being required to contribute 20 percent to 25 percent of their paychecks to the retirement system within the next decade (as shown in the below table). By contrast current city employees only contribute 5 percent of their salary.

When the mandates fully kick in, it will be impossible for Phoenix to hire good workers in the future – who wants to pay a quarter of their salary into the city’s pension fund? Or the city will have to significantly raise workers’ salaries to make up for the requirements and increase their take home pay.

The Phoenix Pension Reform Act fixes the recruitment problem by creating a 401(k) system for new hires and slowly phasing-out the current system. And the financial flexibility created by the new system will also allow the city to provide more competitive salaries, which helps in recruiting the best talent possible.

Unfunded Liabilities

The proposed Act also indirectly addresses the unfunded liability problem in Phoenix. Because the current pension system would be phased-out and replaced with 401(k) accounts, the city would accrue no additional pension liabilities beyond those presently projected unless it is wrong about its estimated investment rate of return on pension assets.

Phoenix is currently using an unrealistic 7.5 percent assumed rate of return on its investments. If actual returns on pension assets are just a quarter-percent lower at 7.25 percent then taxpayers would wind up paying nearly $100 million in extra costs over the next two and a half decades. If average returns for the coming 25 years are closer to Moody’s Investor Service’s proposed average assumed rate of 5.5 percent, then Phoenix taxpayers will be bled of $700 million more than is currently projected.

Any losses the City suffers in the coming years from unrealistic actuarial assumptions will come with or without reform. However, a benefit of the Phoenix Pension Reform Act is that no more liabilities would be added to the system and that means less debt on net down the road for taxpayers to deal with. Beyond this, the most the City could do is change its assumptions now, recognize that the current unfunded liability is larger than presently accepted, and start paying the higher debt bill off.

A related benefit of the Act is that by the time all current workers retire under the new system, taxpayer exposure to unfunded pension system will be eliminated (again, presuming the system’s pre-funding is properly managed).

Understanding the Different Cost/Savings Estimates

The biggest question, though, is what are the costs of the proposed Act. That is what the City’s actuary sought to do, and that is what our analysis attempts to do. So why the difference between our two numbers?

Under the status quo, Phoenix is projected to see declining contribution rates to the retirement system as the 50/50 cost sharing kicks in with new hires. However, the creation of a defined-contribution system would change the arrangement so that the City wouldn’t be sharing as much of the cost of retirement benefits with current employees.

For instance, if the City created individual retirement accounts and contributed 7-percent of pay into those 401(k) style funds, the cost of that plus the ongoing costs of funding defined-benefits for workers still in the old system would be greater than just maintaining the status quo.

That’s not a so-called “transition cost” its just the “cost” on paper comparing the current projected decline in contribution rates vs. the cost of a defined-contribution system.

But we think this story is too simple. First, it is poor financial management to ignore the savings elements of the Pension Reform Act. Once we factor in the savings from ending spiking, changing the final average salary calculation, and restricting employees to just one retirement plan, the savings more than cover the projected costs of a defined contribution system. That is what drives our, more comprehensive estimate.

Second, it should be recognized that the status quo is not sustainable (for the reasons mentioned above). The declining retirement contribution costs for the City that the proposed initiative is being measured against are just a gimmicky illusion that will never come to pass in real life.

No plan is perfect, including the Phoenix Pension Reform Act. But on net, this proposed initiative will mean hundreds of millions in fewer costs for taxpayers in the coming decades, prevents the City from facing a serious recruitment challenge, and eventually eliminates all taxpayer unfunded pension liability risks that are inherent in the status quo.