The Arizona State Retirement System (ASRS) is funded using contributions from the state budget, local government employers, and public employees. The annual contribution rates are determined by an actuary working for ASRS, who takes into account the benefits being promised, the assumptions selected by the ASRS board of trustees, and the policies in place for covering the current $13.9 billion funding shortfall.

During the last “actuarial valuation,” actuaries for ASRS determined that the total contributions necessary for the fiscal year from July 1, 2019 to June 30, 2020 (based on the ASRS funding policy framework) should be equal to 25.26% of public sector payroll.

The prior year, the ASRS board adopted a policy to “phase-in” increases in contributions. Based on this policy, the total amount of contributions requested by ASRS of employees and public employers is 23.88%. This contribution rate is divided into two parts, 11.94% from employees (paid from their paycheck) and 11.94% from employers (paid as a percentage of their total payroll).

Here is what these contributions pay for:

  • “Normal Cost” (payments to pre-fund benefits earned this year, assuming the contributions earn 7.5% returns over the next several decades): 14.41%
  • “401h” Health Benefit (payment to pre-fund ASRS provided health benefits): 0.5%
  • “Unfunded Liability Amortization Payment” (Pension debt payments that are intended to backfill the current $13.9 billion funding shortfall): 8.97%
  • Total: 23.88%

Here is how the dollars received by ASRS can be applied:

  • The employee’s 11.94% of salary contribution covers the majority of “normal cost.”
  • That means there is 2.47% of payroll remaining on the normal cost.
  • The employer dollars cover the rest of normal cost, plus other funding needs.

We can think of that breakdown like this:

  • Normal Cost, Employee Share: 11.94%
  • Normal Cost, Employer Share: 2.47%
  • Unfunded Liability Amortization Payment: 8.97%
  • 401h Payment 0.5%
  • Total: 23.88%
  • Total for pension benefits : 23.38%

This means that for every dollar a public employer contributes via their 11.94% of payroll contribution to ASRS::

  • 21 cents goes to pay the employer share of normal cost
    • 2.47% / 11.94% = $0.2069
  • 75 cents goes to pay the unfunded liability amortization payment, or pension debt payment
    • 8.97% / 11.94% = $0.7513
  • 4 cents goes to pay the 401h payment
    • 0.5% / 11.94% = $0.0419

Therefore, we can say that 75 cents (or 75%) of every dollar contributed by a public employer in Arizona is going to cover pension debt payments.

Pension plans are designed to collect contributions from active workers and employers, invest that money to produce a return, and use those combined contributions and investment returns to pay promised benefits. This design means that when a pension plan is working as it should, the fund will hold assets equal to the estimated value of the benefits it has promised to pay. When the value of assets falls below the value of benefits promised, then a pension fund has “unfunded liabilities.”

The Arizona State Retirement System (ASRS) releases an annual “actuarial valuation” that provides data on its existing assets, liabilities, and unfunded liabilities. The most recent report is for the fiscal year ending June 30, 2018. (A report for FYE 2019 is expected within a few months.) In that report, ASRS reports the following —

  • Actuarially accrued liabilities: $54.2 billion
  • Market valued assets: $40.2 billion
  • Unfunded liabilities: $14 billion

The actual reported unfunded liability is $14.01 billion, but we rounded for simplicity. We chose to show unfunded liabilities based on a market value of assets and ASRS’s preferred measure of promised benefits, so as to show the best case scenario from the perspective of the state.

ASRS also reports its financials in two other ways: using “actuarially valued” assets (AVA), and using standardized GASB 68 methodology. The AVA numbers are what pension contributions are based on — ASRS takes any investment gains or losses, and “smooths” them out over 10 years. The GASB numbers are based on a common way to measure assets and liabilities (promised benefits) so that states can be measured from state to state. Under GASB rules, the “net pension liability” is similar to unfunded liabilities.

  • Actuarially accrued liabilities: $54.2 billion
  • Actuarially valued assets: $38.6 billion
  • Unfunded liabilities: $15.6 billion
  • Net pension liabilities (if 8.5% discount rate): $8.988 billion
  • Net pension liabilities (with 7.5% discount rate): $13.946 billion
  • Net pension liabilities (if 6.5% discount rate): $19.881 billion

There are other ways to measure the value of promised benefits too, such as using a “market value of liabilities” — which financial economists use. Under these methods the unfunded liabilities of Arizona are much higher, such as the net pension liability figure using a lower, 6.5% discount rate. For more see Hidden Debt, Hidden Deficits.

Contributions into the Arizona State Retirement System (ASRS) are shared between employees and employers. To determine contribution rates, actuaries for ASRS estimate the value of promised benefits using assumptions about longevity, projected payroll, and investment returns (among other factors). This helps to determine “normal cost” — which should be enough in contributions to pay all benefits earned during a given year, if assumptions are correct and the full amount is paid.

When actuarial assumptions for a given year are not correct — maybe people don’t retire at rates expected or pay raises aren’t as high as anticipated — this produces an actuarial “gain” or “loss.” When losses are higher than gains, a pension fund develops unfunded liabilities. This means the pension fund isn’t projected to have enough in contributions to pay projected benefits — unless assumptions improve in the future or additional contributions are made. The additional contributions are called “unfunded liability amortization payments.”

The combined total of normal cost plus unfunded liability amortization payments that actuaries have calculated — called the actuarially determined contribution — is 25.26% of payroll for fiscal year 2019-20. However, ASRS has a policy for phasing-in increases in contribution rates, which reduces the contribution for FYE 2020 to 23.88% of payroll. As a result, the current contribution breakdown for ASRS is as follows:

  • Normal Cost: 14.41%
  • 401h Health Benefit: 0.5%
  • Unfunded Liability Amortization Payment: 8.97%
  • Total: 23.88% of payroll

This amount is divided equally between employees and employers, such that each pays 11.94%, which we simply rounded to 11.9%.

The Arizona State Retirement System (ASRS) is currently not offering any form of inflation protection on existing or future pension benefits. Most pension funds around the country offer retirees a periodic cost-of-living adjustment (COLAs), often based on actual inflation (measured using the Consumer Price Index). In fact, Arizona’s pension fund for police and fire offers a COLA that is linked to both local levels of inflation in Arizona, and the funded status of the Public Safety Personnel Retirement System. However, ASRS historically has not paid out COLAs.

Instead, ASRS has a program called “permanent benefit increase” or PBI. The way PBIs are supposed to be paid is through a separate, dedicated fund of money. This separate pot of money is intended to be funded using “excess” investment returns. The problem is that it is really hard to accumulate excess returns.

ASRS only has excess investment returns when the actual rate of return is greater than 8% over a 10-year smoothed period. That is, when taking 1/10th of an actual investment return for each year of the past 10-years, the total needs to be 8%. And ASRS hasn’t achieved this since at least 2005.

As a result, there is no money to pay out PBIs, and it is highly unlikely that there will be any in the near future, as forecasted returns show that there is at best a 50/50 chance of earning 7.5% on average (which is the assumed rate of return used by ASRS).

Even if there are excess returns available in the future, employees hired after September 13, 2013 are not eligible for any PBI. This change was adopted by the legislature because they were concerned about growing costs of ASRS (driven up by unfunded liability amortization payments) and the need to ensure all investment returns are used to reduce unfunded liabilities.

The primary factor creating unfunded liabilities for ASRS is investment returns being lower than expected (see Equable’s analysis here, as well as analysis from Reason Foundation and Urban Institute). And the same issue — lower than expected investment returns — has meant no excess funds for PBIs. Thus, the same factors driving up ASRS costs and creating pension debt owed to ASRS, are preventing Arizona from being able to offer some kind of inflation protection on pension benefits.