Financial Markets in 2012 by Gary Trennepohl

Financial Markets in 2012: Where are the Stories? Strictly Financials Jan. 5, 2012

Donald W. Reynolds National Center For Business Journalism At Arizona State University Strictly Financials 2

 Gary Trennepohl, Ph.D.  ONEOK Chair and President’s Council Professor of Finance  Oklahoma State University  Trustee, Oklahoma Teachers Retirement System  Member, OSU Foundation Investment Committee gary.trennepohl@okstate.edu Strictly Financials 3

Major Economic Themes for 2012 I. Survival of the “Euro” and the Eurozone  Defaults by Greece, Italy, Portugal or Spain?  The impact on international trade II. The U.S. Budget and the 2012 election  The budget and the budget deficit  Entitlement programs  Social Security and Medicare III. Issues surrounding Pension Funds  Public workers’ pensions  State budgets and public pensions Strictly Financials 4

The Economist, Nov. 26, 2011, asks:“Is this Really the End? Unless Germanyand the ECB move quickly, the singlecurrency’s collapse is looming.”I. WILL THE EURO SURVIVE? Strictly Financials 5

A. An Historical PerspectiveAbout Exchange Rates is Useful Strictly Financials 6

Exchange Rates 1875 to 1944 The “Gold Standard” system (1875 to 1914) Currencies were pegged to gold and exchange rates were easily determined:  If £1 = 1 oz of gold and 1$ = ½ oz of gold, the $/£ exchange rate was $2 = 1£ (1/½ = 2).  But this system creates lots of internal problems in an economy. The Interwar Period (1915 -1944)  Gold standard abandoned, trade wars, Great Depression and bank failures Strictly Financials 7

Exchange Rates 1945 to Present “Bretton Woods System” (1945 to 1972) Exchange rates were fixed and based on the US $ ($35 = 1 oz of gold).  Became economically unsustainable in late 1960’s because of the growth of world trade. “Flexible Exchange Rate” system (1973 to present)  Major trading currencies allowed to float in value against each other  Market forces of supply and demand determine exchange rates. Strictly Financials 8

Factors Affecting Exchange Rates Interest rates and expected inflation  Higher real interest rates (interest rate – inflation) attract buyers for dollars and vice versa. Income levels (wealthy vs. poor states) Government controls  Foreign exchange barriers  Trade barriers and tariffs  Central banks buying/selling of currency Expectations  Captured by trading in foreign exchange futures Strictly Financials 9

B. What about the EuroAnd the European Union? Strictly Financials 10

The European Union Created by the Maastrict Treaty in 1991 Introduced the Euro (€) in 1999 at a value of $1.18 per €1. 16 countries now use the €  Austria, Belgium, Cyprus, France, Finland, Germany, Greece, Ireland, Italy, Kosovo, Luxemborg, Malta, Netherlands, Portugal, Solvenia, Spain.  Denmark, Sweden, and the U.K. do not use the € but are part of the European Union. Strictly Financials 11

Why have a Monetary Union? Advantages:  Reduces costs (dramatically)  Eliminates exchange rate uncertainty  Promotes trade and political cooperation Disadvantages:  Loss of monetary independence and control  Tensions between “rich” and “poor” states  Difficulties in maintaining unified control Strictly Financials 12

Key Criteria for Membership Ratio of Budgetary Deficit to GDP ≤ 3%  U.S. is 10.64% in 2011 budget  EU is 6.3% in 2010 Ratio of Gross Public Debt to GDP ≤ 60%  U.S. is 94.27% in 2010  EU is 74.0% in 2010 But, most members violate these measures, and have done so through time. Strictly Financials 13

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So, What’s the Problem? Sovereign default is possible  Greece, Ireland, Portugal and Spain may be unable to repay or refund debt as it comes due. But, because most of the debt is held by European banks, the EU set up a bail out fund for Greece and Ireland (so far). What impact will the fear of a debt crisis in Europe have on the international banking system and interest rates? Strictly Financials 15

Story Possibilities 1. What impact will death of the Euro have on businesses in your city? 2. Do banks/pension funds/investors in your city or state hold foreign bonds? 3. Do companies in your area do business with Greece, Portugal, Ireland or Spain? Strictly Financials 16

U.S. Companies AndCurrency Exchange Rates

Importers, ExportersAnd Exchange Rates U.S. exporters  Benefit from a weak dollar (U.S. wheat becomes cheaper to Russians).  Hurt by a strong dollar U.S. importers  Benefit from a strong dollar (BMWs can go down in price for U.S. buyers)  Hurt by a weak dollar Strictly Financials 18

U.S. Multinationals ThatOwn Businesses Abroad It is estimated that 40% of the earnings from the S&P 500 companies are derived from foreign operations. The impact of the dollar’s value on their operations becomes much more difficult to measure. However, each year on their financial statements, their gain/loss on foreign currency exchange is booked in the equity section of the balance sheet. Strictly Financials 19

Story Ideas1. How are businesses in your city impacted by the value of the $?2. What is the impact of the $’s value on the global recovery?3. Will a “weak dollar” policy help or hurt industries in your area?

The U.S. Budget Crisis and 2012 Election1. The U.S. Budget Deficit: Is it too much spending or too little tax revenue?2. The Budget and Entitlement Programs.

Look for Congress to AddressEntitlement Spending to MakeProgress on the Budget Deficit Strictly Financials 25

Will Social SecurityBe Your Security?

Social Security and Medicare:The Looming Political Crisis Social Security (taxes paid on income up to $110,100 in 2012)  Provides retirement benefits for a worker and his/her spouse to the second death  Provides disability benefits to injured workers regardless of age  Provides survivor benefits to widows and eligible children to age 19 (or 22). Medicare (tax paid on total income)  Provides hospital insurance at age 65 and above  Don’t forget to register before you turn 65! Strictly Financials 29

FAQs Regarding the SSA How much can I earn and still receive benefits?  After reaching full retirement age (FRA), your SS benefits will not be reduced, but…  If your income is over $44,000 (joint) 85% of benefits will be taxable. At what age should I start taking Soc Sec benefits – 62 years, 66 years, 70 years?  Also, keep in mind that SSA and Medicare are independent decisions. You have to sign up for Medicare at 65 but you don’t have to start drawing SS benefits. Strictly Financials 30

Social Security Myth 1 “There’s a lockbox that keeps and invests the FICA taxes you pay.” No, not really  Taxes paid by current workers are used to pay the benefits of current retirees. You don’t have an individual account with your money in it, just a ledger balance at the SSA.  Surpluses are deposited in the “Social Security Trust Fund,” which then buys non-marketable U.S. Government bonds. In reality, this goes directly to fund the Federal deficit. Strictly Financials 31

Current Status of Social SecurityTrust Fund (from the 2011 Social Security Trustees Report)  In 2010, Social Security costs exceeded income from payroll taxes for the first time  Recession reduced payrolls  Baby boomers started to retire (we already know this – they’ve been around for 65 years)  After 2012-14, costs will exceed income so interest payments from trust fund will be needed to fund payments.  After 2022, taxes and interest will be insufficient so the trust fund corpus will have to be used to fund benefits. Strictly Financials 32

What About the Trust Fund? In 2036 the trust fund will be exhausted  But, yearly payroll taxes could still pay about 75% of current benefits. Assuming no new legislation, the “replacement rate” (Social Security benefits/pre-retirement earnings) would drop from 41% today to 36% in 2036 to 29% in 2037. If payroll taxes immediately were raised by 1.92% (ie. .96% each for worker and employer), the 41% benefit level could be maintained to 2086. Strictly Financials 33

Social Security Myth 2 “I don’t count on Social Security because it will be broke when I retire.” Not True.  This is a legal obligation of the U.S. Government, which it really cannot choose not to pay.  Do you really think the government can renege on its promise to pay your benefits that you have already paid for?  What if your employer decided it was not going to pay your retirement benefits that you had been promised?  A politically explosive issue Strictly Financials 34

What Should Congress Do? Increase SS retirement age?  Originally set at 65 in 1935, but life expectancy has dramatically increased. Increase income tax on SS benefits?  Currently, if your taxable income exceeds $44,000 (joint), 85% of SS benefits become taxable. Uncap the wage level for payroll taxes (set at $110,100 for 2012)?  Medicare taxes currently are uncapped Increase the payroll tax?  By 1.96% total as shown earlier Strictly Financials 35

What About Medicare AndNew Healthcare Legislation? The real economic issue is spending on healthcare. Future Social Security benefits/costs can be mathematically determined so it becomes a political problem to solve; medical costs cannot be estimated with any accuracy. Strictly Financials 36

Information about Social Security Center for Retirement Research at Boston College. http://crr.bc.edu/ List of publications at: http://crr.bc.edu/social_security/soci al%2520security%3bbriefs.html Strictly Financials 37

Story Ideas1. Do your readers believe that Social Security will pay them retirement benefits?2. Do they favor changes to the system that will insure its survival – (1) increase retirement age, (2) increase taxes, (3) increase taxable wage base?3. How does Social Security fit in your retirement planning? Strictly Financials 38

Will the Coming CrisisIn Public Pension PlansAffect Your Community? Strictly Financials 39

Some Recent Headlines About Public Pension Plans “Padded Pensions Add to New York Fiscal Woes”  Walsh and Schoenfeld, NY Times, May 21, 2010. “Studies Show Grim Outlook for Public Plans”  Burr, Pension & Investments, Oct. 12, 2010. “Can the Illinois Pension Catastrophe be Stopped?”  Novy-Marx, and Rauh, Chicago Tribune, Aug 13, 2010. “State Pension Plans Go Broke as Payrolls Expand”  Mysak, Bloomberg Opinion, Jun 10, 2010. “Pension Woes May Deepen Financial Crisis for States  Keith, NRP News, Mar 21, 2010. Strictly Financials 40

Grabbing Headlines*  “After 30 years of service, a police officer in California can retire at 90% of his final compensation. The monthly benefit will increase each year by a 2% cola.”  An officer earning $150,000/year will retire earning $140,000/year for the rest of his/her life, for a total benefit of $5.9 million (to age 85).*”Taming a Whale Lurking in Pension Financing”, Bruce DealPensions and Investments, August 9, 2010 , p 12. Strictly Financials 41

States Making Changes to Public EmployeePension Plans – 2009: (The Pew Center on the States) Strictly Financials 42

States Making Changes to Public EmployeePension Plans - 2010 Strictly Financials 43

Two Principal TypesOf Pension Plans Strictly Financials 44

Defined Benefit Plans Employer assumes obligation to pay retirement benefits defined by formula.  Retirement benefits determined by a calculation:  eg. = (years service*2%*avg. 3 yr highest salary) Most public plans are of this type. Market risk is carried by the state sponsor and the investments are professionally managed. No asset available to transfer to heirs. $4,357 billion of assets in DB plans (as of Sept 30, 2009) Strictly Financials 45

Defined Contribution Plan Employer only assumes obligation to pay yearly % of salary (eg. 10%) into employee selected investment vehicle (think 401-k). Individual bears the market risk and is responsible for selecting investment vehicles. Retirement benefits determined by performance of investment choices. Most newer corporate plans are of this type. Value of assets becomes part of estate that can be transferred to heirs $1,720 billion of assets in DC plans (as of Sept 30, 2009) Strictly Financials 46

Ten Largest Defined Benefit Funds* Total Assets in Billions of $ State of New Jersey Wisc. Investment Brd. NY State Teachers Gen. Motors Texas Teachers NY City Retirement Fla. State Board NY State Common Calif. State Teachers Calif. Public Emp. $0 $50 $100 $150 $200 $250* as of Sept. 30, 2009* from Pensions&Investments, Dec 28 and Feb. 8, 2010) Strictly Financials 47

Typical Pension Plan Sponsors State or municipal employee plans (almost all are defined benefit plans):  Teachers (K-12, community colleges, universities)  State employees  Firefighters and Police  Judges Local union plans (usually defined benefit plans) Corporate plans (most have converted to defined contribution plans) Strictly Financials 48

Measuring Pension Plan Health Actuaries can project future plan liabilities and income – key factors are:  Workforce demographics  Rate of return assumptions  Mortality rates – and we are living longer  Size of investment portfolio  COLAs – “cost of living allowances (eg. 2% a year) The “present value” of projected pension payments and income to the plan is used to calculate the “funding ratio”: $ projected payments/$ income  A funding ratio of at least 80% is considered “safe” Strictly Financials 49

Funding Levels of Public Plans* Strictly Financials 50

What the Future Holds In 2008 most plans were funded at over 80%, but by 2009 only 36% were.  Falling stock market reduced portfolio values  Reduced contributions from states as they struggled to balance budgets. Alternatives for state and local government plans  CA, IL, NJ may need to increase contributions to 8-12% of state budgets to keep plans solvent.  Most states need to increase contributions an additional 2% of state budget to get funding up to 80%.  Experiences of Minnesota and Colorado to change plan benefits. Strictly Financials 51

Story Ideas1. What is the financial health of pension plans in your area? (Public plans have to provide data.)2. Are plan administrators considering actions to modify plans? What resistance is expected?3. What has been the financial performance of the fund over time? Is it competitive with other plans?4. What is retirement pay for high paid employees? Strictly Financials 52

Resources “Covering your local pension plan”  SABEW Teletraining, Dec. 5, 2011  http://sabew.org/2011/12/covering-your- local-pension-plan/  Detailed tutorial by David Milstead  Advice from Barlett and Steele winner Craig Harris of the Arizona Republic  Overview from the National Council of State Legislatures Strictly Financials 53

Financial Markets in 2012 by Gary Trennepohl

by Reynolds Center for Business Journalism on Jan 05, 2012

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Financial Markets in 2012 by Gary Trennepohl — Presentation Transcript