Reforming Arizona’s Public Safety Personnel Retirement System

Good morning Senator Lesko and Committee Members. Thank you for allowing me the opportunity to be here today. My name is Pete Constant and I am the Director of the Pension Integrity Project with the Reason Foundation. The Reason Foundation is a 501(c)(3) nonprofit public policy think tank.

The goal of our Pension Integrity Project is to both advocate for reform and to assist policymakers in implementing necessary changes in state and local public pension systems in order to provide retirement security for all employees and retirees, while reducing taxpayer and pension system exposure to financial risk and market risk.

Just about a year ago, public safety officers, led by the Professional Fire Fighters of Arizona, approached the legislature with the idea of reforming the pension system in order to ensure retirement security for the men and women that work diligently to ensure the safety of Arizona residents.

Senator Lesko subsequently convened a stakeholder group to look at the Public Safety Personnel Retirement System – PSPRS – and explore how we might be able to reform a system that has seen its funding ratio drop to 48%, its unfunded liabilities grow to a staggering $6.6 Billion [slide 4], and employer contribution rates rise to unaffordable levels [slide 8].

Keep in mind that this low level of funding was as of last June when the financial markets were at an all time high.

The stakeholders worked together to critically examine the system as it currently operates, explore and analyze a variety of potential reform options, and develop a consensus amongst active employees, retirees, cities and towns, counties, and Senate leadership on a reform package that repairs structural flaws in the system, provides retirement security and certainty for employees and retirees, slows the accrual of liabilities, lowers the normal costs for cities, counties, and state agencies, and most importantly, reduces future taxpayer risk. This lower risk will minimize the volatility of contribution rates for employers and provide much needed relief to public agency budgets across the state.

I need to pause here for a moment to comment on how unprecedented this is on a number of fronts. First, this is the first instance that we are aware of where public safety unions have come forward of their own volition to promote pension reform. Secondly, the stakeholder process that Senator Lesko led is also unprecedented in its approach of bringing all stakeholders together to work towards a common purpose and consensus on pension reform. This should serve as an example of how good public policy is crafted.

As you are well aware, the path to pension reform is fraught with peril and legal risk. In fact, a multitude of court cases have stacked the deck against reform. Oftentimes reform efforts fail due to the state constitutional protections against the diminishment of pension benefits and the significant and strict court interpretations of the federal constitutional contract protections.

The stakeholders paid particular attention to these issues and have developed a reform package that will deal with the state constitutional issues via a constitutional amendment, and is designed to withstand court scrutiny of the contract issues.

Now I would like to explain to you what this reform actually proposes. The changes to the PSPRS system fall into three categories: how they affect current employees and retirees, how they affect future employees, and how they affect the governance of the plan.

Current Employees: There is one change that will affect all current employees and retirees. This is a change to the Permanent Benefit Increase – PBI – that is provided to retirees as a method to increase retirement benefits over time to assist with changes in the cost of living during retirement. The PBI as it exists is fundamentally flawed. This benefit is funded by taking 50% of excess market returns (over 9%) and reserving them solely for the purpose of paying out the PBI benefit.

There are two major flaws with this methodology. The first is that this is “one time” money that permanently increases a retirees benefit for all future years, creating an ongoing liability. And for decades – in fact, until last year – the plan and their actuaries failed to account for these long-term liabilities in the calculation of the plan’s normal costs, creating unfunded liabilities. Second, by removing these “excess” earnings in years of strong market returns, they were no longer available to offset the many years that the plan failed to achieve its assumed rate of return. For over 20 years the PBI has distributed 4% benefit increases annually – even as the plan experienced losses.

Actuaries, the PSPRS board, and others have identified this PBI as significantly contributing to the steady decline in funding status of the plan. Additionally, the PBI fund has become insolvent and unable to – for the first time in over 20 years – pay a benefit last year. Given the fiscal year-to-date performance of the financial markets it is very unlikely a PBI will be paid out this year. Yet anytime in the future the fund earns a market return over 9% it will pay out a benefit increase.

This reform replaces this broken PBI benefit with a more predictable, pre-funded cost of living adjustment that is tied to the CPI for the local area, with a cap of 2%.

That is it. Replacing a broken PBI with a well-structured, predictable COLA that is prepaid and provides certainty for retirees.

Future Employees: For future employees there are a number of significant changes to the pension benefit.

For the first time, all new public safety employees will have the option of selecting a defined contribution only plan. Employees will be provided with a professionally managed defined contribution plan, with matching contributions consisting of 9% each by the employee and their employer. Employer contributions will vest over a 10-year period (immediately in event of death or disability) and there will be reasonable safeguards in place to ensure adequate long-term financial security.

An employee may choose instead to enter into the defined contribution plan, a plan in which all costs are split 50/50 between employers and employees, including normal costs, future Tier 3 unfunded liability amortization costs, and administrative costs – with no caps on either the employer or employee contribution rates. It is important to note that these members will only contribute to any future unfunded liabilities on the obligations of the Tier 3 Plan and no other PSPRS tier.

The pension benefit will be based on a stepped multiplier: starting at 1.50% for 15.00 years of credited service, and stepping up to 1.75% at 17.00 years of service, 2.00% at 19.00 years of service, 2.25% at 22.00 years of service, and finally 2.50% for 25 or more years of service.

These members will also have the same capped CPI-based cost of living adjustment as the existing employees and retirees, with one significant difference. The cap of 2% will drop to 1.5% if the funded ratio of that tier drops below 90%, 1% if the funded ratio drops below 80%, and will be suspended entirely in years where the funded ratio falls below 70%.

Additionally the reform reduces the cap on pensionable compensation from $265,000 to $110,000, significantly limiting pension spiking, and increases the minimum benefit eligibility age from 52.5 years old to 55 years old.

For new employees not enrolled in Social Security, they will also be provided with a defined-contribution plan with contributions consisting of 3% each by the employee and their employer. This benefit will be also provided to existing employees hired after 2012 who are not in social security.

Governance: The composition of PSPRS Board of Trustees will be modified to reflect the 50/50 sharing of costs and risks of the new retirement formula. This expanded nine-member board will have 5 independent professionals and 4 members representing employees.

In order to ensure that no new retroactive benefits are granted to employees in the future, any new unfunded liabilities associated with any benefit increase will be required to be fully paid in the year of enactment and cannot be amortized over any period of years.

Additionally, moving forward, at no time will any employer’s or employee’s annual payment to PSPRS be less than their share of the actuarially determined normal cost. No credits against normal cost will be allowed. Believe it or not, even with the 48% funded status, it is still possible for some employers to get a credit against normal costs.

And finally, this legislation will incorporate comprehensive fiduciary standards in Arizona statute.

As I previously mentioned, this comprehensive reform package will lower the normal costs for cities, counties, and state agencies, and most importantly, reduces future taxpayer risk. The current employer normal cost for new hires is 13.2% of payroll. Under the proposed reform, employer normal costs for new hires will vary from 7.53% for employees in social security, to 10.53% for employees not in social security, and 9% for employees that select the defined contribution only plan. These numbers have been provided to us by the PRPRS plan actuary and have been confirmed by our own independent actuary.

As you can see, employer normal costs for new hires will be less for each new employee hired and will provide that much needed budget relief for public safety employers and taxpayers. Over the next 30 years the reform will result in $1.5 Billion and a 36% reduction in accrued liabilities [slide 28]. Just as important, the volatility of the plan will be reduced by more than half, bringing stability to contribution rates [slides 31-32].

Unfortunately, nothing in this reform will relieve employers of the unfunded liabilities for benefits accrued and owed to current employees and retirees. As I mentioned at the top of my remarks, there are very significant legal impediments that prevent reforms that will reduce benefits already promised and earned. However, employer total contributions for retirement will drop overtime, and once the unfunded liability is paid off in about 19 years, the cost reductions will be significant [slide 24].

The stakeholders feel very confident that this reform will deal with the state constitutional issues via a constitutional amendment and is designed to withstand court scrutiny of the contract issues.

I am available to answer questions or provide clarifications if necessary. Thank you for the considerable time you afforded me to go through this complicated issue.