Rebuilding trust, funding puts Arizona plan back on track

Updated with clarification on contributions

After years of declining funding, the firing of its previous two top officials and a lack of trust from the hundreds of state employers it serves, the Arizona Public Safety Personnel Retirement System is making an impressive comeback.

The Phoenix-based multiemployer retirement system has not only successfully restored its relationships with more than 300 municipal, county and state public safety-related employers whose assets feed the system, but communicated the urgency of increasing contributions to the system to bring it out of its funding hole.

The result is a spike in system assets that made it the fastest-growing U.S. retirement plan in the year ended Sept. 30, according to Pensions & Investments data. During a period of significant market volatility and double-digit negative public equity and fixed-income performance, the system’s assets grew 13.3% to $18.3 billion during the period thanks to outsized contributions.

Among the top 200 retirement plans during the year ended Sept. 30, PSPRS was one of only six U.S. retirement plans that had an increase in assets, with the next highest spike — by Seattle-based Amazon.com Inc. — far behind at 2.7%.

As impressive as that statistic is, PSPRS was also the second-highest gainer the year before, with assets going up 44.3%, a period in which nearly all plans had double-digit investment returns. In the two years ended Sept. 30, defined benefit assets rose to $17.8 billion from $10.5 billion.

During the fiscal year ended June 30, public safety employers in Arizona made $2.85 billion in additional contributions to the retirement system beyond the actuarially required amount, and the total for the past three years is $4.86 billion. The result was a dramatic increase in the system’s funding ratio to 65.3%, up from 54.1% a year earlier and 46.9% the year before that.

Additionally, with such large contributions, investment staff has had more freedom to implement their investment strategies and take advantage of large cash holdings.

Michael Townsend, administrator of the system who was hired in 2019, said in an interview he was a certified public accountant who had spent 25 years in Arizona city and county government prior to taking the job at PSPRS. His interest in pension funds had developed during his time as a member of the board of trustees (including a stint as chairman) at the $48 billion Arizona State Retirement System, Phoenix.

Also, since 2007, he had served as deputy county manager of Coconino County where he oversaw initiatives to increase that county’s public safety pension funds’ funding ratio to more than 70% from as low as 25%.

In coming to PSPRS, Mr. Townsend said, “I really thought I could make a difference with my understanding of government work and my understanding of pensions and how to explain it to people.”

It was a tall order. The system’s previous administrator, Jared Smout, was terminated by the board of trustees by unanimous vote in June 2019 for “inappropriate behavior and workplace harassment,” and his predecessor, James Hacking, was terminated in July 2014 for initiating salary hikes for some investment staff without proper approval.

The good news was that Arizona had enacted legislation in 2016 to address the funding crisis, which included creating a new tier of defined benefit plan participants beginning July 1, 2017, and also created a new defined contribution plan that newly hired employees had the option of selecting instead of the DB plan. While the legislation helped matters, there was still far more to do, Mr. Townsend said.

“It was actually worse than I thought,” Mr. Townsend said. “I think I was there about three months and the CFO at the time decided to resign … we (now) had one CPA on staff at the pension system, and I was it.”

The beginning of the rebuilding of the system was hiring Foster & Foster as its new actuarial consultant replacing Gabriel, Roeder, Smith & Co.; and CliftonLarsonAllen LLP as the new auditor replacing Heinfeld Meech & Co. Mr. Townsend said one of the most important moves was hiring Clark Partridge, retired Arizona state comptroller, for the new position of senior executive consultant.

“I wanted someone who understood accounting and actuarial valuations who could work with individual employers,” Mr. Townsend said. Mr. Partridge also had the benefit of having relationships with all the state agencies.

With a mandate to improve the funding of the system, Messrs. Townsend and Partridge began to reach out to the hundreds of pension funds in the state to talk about not only the necessity of making additional contributions, but also building relationships with the employers to re-establish trust in the entire system.

“Really, pensions are hard to understand anyway,” Mr. Townsend said. “Then, given the history of PSPRS, there was no trust. No one knew what was going on.”

At the beginning of 2020, Mr. Townsend and his staff were ready to roll out presentations, and then the COVID-19 pandemic hit. And while “it’s hard to find a silver lining for the pandemic,” Mr. Townsend said the necessary Zoom meetings allowed Mr. Partridge and him to meet with more employers than otherwise, particularly in rural areas.

The key to understanding the importance of improving the funding, he said, was not only giving the employers and their boards of trustees an understanding of the issues at hand, but also giving them access to financial advisers to assist them in their efforts, along with the tools to educate their taxpayers to get behind initiatives that might be necessary to increase funding.

This could include issuing debt that would have to be approved by any given municipality’s voters, and that meant convincing them that with interest rates at a historic low, the timing was perfect to issue debt.

“Our investment chair, he makes reference a lot to that once-in-
a-generation event,” Mr. Townsend said. “There’s nobody on our board who even remembers rates being that low in their lifetime.” Mr. Townsend did note that debt issuance was not the only method that municipalities used to increase contributions. Sometimes it was simply a matter of increasing contributions through existing cash reserves.

With the third tier of employees established in the 2016 pension reform legislation, the system has the tools to make sure the decline in funding does not happen again.

Now that the funding level has dramatically increased, Mark Steed, the system’s chief investment officer, has the opportunity to put his investment strategy in place. Mr. Steed, who was hired as CIO in October 2018 following the retirement of Ryan Parham, had joined the system in 2007 as a portfolio analyst and moved up the ranks to lead portfolio manager, then chief of staff and then deputy CIO.

“When I started, it was generally really clear that we didn’t have a lot of confidence from our beneficiaries just in terms of what we were doing because it seems there was always some sort of drama and it made it really hard to establish legitimacy,” Mr. Steed said in an interview. And, he added, “at a very high level we just needed better investment outcomes.”

Mr. Steed said the system’s low funding ratio meant taking on considerably more risk.

“It’s very risky when you have a big drawdown of 10% to 15% and you have a negative cash flow out of the system,” Mr. Steed said. “(It’s very risky) even if you hit expectations every year.”

Mr. Steed said that Mr. Townsend and his staff’s efforts to re-establish trust with the employers was also at least as important as the added contributions themselves.

“They weren’t really confident you were going to invest wisely,” Mr. Steed said, adding that having Mr. Townsend in place, someone who used to be in the seat of an employer who was obviously bright and intelligent, was vital.

Due to the increased contributions, the system has had the advantage of being able to maintain a large allocation to cash. As of June 30, the actual allocation to cash and short-term investments was 15.7%.

“We have all this cash now,” Mr. Steed said. “Fortunately, that’s a good thing in this environment … in a perfect world, you would just deploy it across all the asset classes.”

However, given the difficult market environment that saw the Russell 3000 index and Bloomberg U.S. Aggregate Bond index return -13.9% and -10.3%, respectively, during the year ended June 30, Mr. Steed and his staff elected to keep contributions in cash.

As a result, PSPRS’ exposure to public equities was limited to 20.5% and 13% in domestic and international strategies, respectively, well below their respective targets of 24% and 16%. Further benefiting the system was a target of only 2% to core bonds.

As a result, the pension fund’s net return for the fiscal year ended June 30 was -4%, well above its benchmark return of -10.5%.

PSPRS’ investment trust consists of assets of the Public Safety Personnel Retirement System, Elected Officials’ Retirement Plan and Corrections Officer Retirement Plan.