Strictly Financials 2014: Financial Markets in 2014 - Story Projects by Gary Trennepohl


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Gary Trennepohl presents "Financial Markets in 2014: Story Projects" during the Reynolds Center for Business Journalism's annual Business Journalism Week, Jan. 5, 2014. Trennepohl is the ONEOK Chair of Finance at Oklahoma State University.

The annual event features two concurrent seminars, Business Journalism Professors and Strictly Financials for journalists.

For more information about business journalism training, please visit

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Strictly Financials 2014: Financial Markets in 2014 - Story Projects by Gary Trennepohl

  1. 1. Financial Markets in 2014: Story Projects Strictly Financials Jan. 5, 2014
  2. 2. Donald W. Reynolds National Center For Business Journalism At Arizona State University Strictly Financials
  3. 3. n  Gary Trennepohl, Ph.D. n  n  n  n  n  ONEOK Chair and President’s Council Professor of Finance Oklahoma State University Trustee, Oklahoma Teachers Retirement System Member, OSU Foundation Investment Committee Strictly Financials
  4. 4. Story Topics for 2014 n  Public pension plans – their status and impact on state and local budgets and services. n  Social Security and Medicare – what are the issues? n  Preparing financially for retirement n  Addressing U.S. tax reform and budget deficits n  Corporate governance, pension funds and activist investors Strictly Financials
  6. 6. Ten “Best” and “Worst” States for Pension Funding* n  The Best: 1.  2.  3.  4.  5.  6.  7.  8.  9.  Wisconsin South Dakota North Carolina Washington New York Tennessee Delaware Florida Wyoming n  99.95% 96.3% 95.3% 93.7% 92.7% 91.5% 90.7% 86.7% 85.6% *; Sept. 9, 2013: Based on Funded ratio % Strictly Financials The Worst: 1.  2.  3.  4.  5.  6.  7.  8.  9.  Illinois Kentucky Connecticut Louisiana New Hampshire Hawaii/RI Kansas Colorado Alaska 43.3% 53.4% 55.0% 56.2% 57.4% 59.2% 59.2% 60.0% 61.9%
  7. 7. Ten “Best” and “Worst” Cities for Pension Funding* n  The Best: 1.  2.  3.  4.  5.  6.  7.  8.  n  Vancouver, WA Lincoln, NE Portland, Maine Milwaukee, WI/Cheyenne, WY Knoxville, TN Dover, DL Chattanooga, TN / Montpelier, VT Charlotte, NC / Greenwich CN The Worst: 1.  2.  3.  4.  5.  6.  7.  8.  9.  10.  Little Rock, AR Chicago, IL Aurora, IL Charleston, WV Reno, NV Springfield MA Bakersfield, CA Stockton, CA Saginaw, MI Portland, OR *; Nov. 4, 2013: Based on pension costs as a % of tax revenues Strictly Financials
  8. 8. Two Principal Types Of Pension Plans Defined Benefit Plans (eg. most public plans) Defined Contribution Plans (eg. 401Ks)
  9. 9. Defined Benefit Plans n  Employer assumes obligation to pay retirement benefits defined by formula. n  Retirement benefits determined by a calculation: n  n  n  n  n  eg. = (years service*2%*avg. 3 yr highest salary) Market risk is carried by the state sponsor The investments are professionally managed. No asset available to transfer to heirs. Most public pension plans are of this type Strictly Financials
  10. 10. Defined Contribution Plan n  n  n  n  n  Employer only assumes obligation to pay yearly % of salary (eg. 6%) 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 Strictly Financials
  11. 11. Typical Pension Plan Sponsors n  State or municipal employee plans (almost all are defined benefit plans): n  n  n  n  n  n  Teachers (K-12, community colleges, universities) State employees Firefighters and Police Judges Local union plans (usually defined benefit plans) also called Taft-Hartley plans. Corporate plans (most have converted to defined contribution plans) Strictly Financials
  12. 12. Actuaries are hired to evaluate plans each year – they love it! n  They project future plan liabilities and income – key factors are: n  n  n  n  n  n  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) They calculate the “ARC”, annual required contribution, which is the amount that must be deposited to the plan each year to fund the benefits earned by participants that year. Strictly Financials
  13. 13. Two Measures of Pension Plan Health n  The “Funded Ratio” n  n  n  The (“actuarial value” of assets)/(”actuarial value” of liabilities). 100% indicates a fully funded program. A funding ratio of at least 80% is considered “safe”. Much controversy the past five years over the rate used to calculate the present value of the liabilities for public plans. The “Funding Period” n  n  Number of years under current funding assumptions, it will take for the plan to reach fully funded status A plan currently fully funded will have a funding period of 1 year, while a poorly funded plan could have a period of infinity. Strictly Financials
  14. 14. Vested Interests Will Always Argue Their Plan is the “Best”, But … n  n  n  Either plan will work if it is properly funded and the participants are educated about pension “finance”. Typically, public DB plans are under funded because governments don’t contribute the ARC each year, or add benefits without funding them. DC plans may not produce sufficient retirement income because yearly contributions are too small or investment choices are poor. Strictly Financials
  15. 15. Comparison of DB and DC Plans n  Portability between employers: n  n  n  DC plan assets are portable and belong to the recipient. DB plans ARE NOT. They were designed for the career employee. Investment Management and Performance n  n  DC plans: Employees must make their own investment decisions DB plans: Assets are professional managed Strictly Financials
  16. 16. Comparisons (cont) n  Market and Retirement Date Risk: n  n  n  Outliving your Retirement Investments n  n  n  DC plan: Employees bear all risk DB plan: No market or retirement date risk DC plan: Employee bears total longevity risk DB plan: No longevity risk; funding is certain. Costs: n  n  DC plan: Typically higher cost per account DB plan: Lower costs per account Strictly Financials
  17. 17. What the Future Holds n  n  n  n  As the stock market causes funded ratios to improve, will governments “underfund” pension plans to meet other budget obligations? Do politicians have the will to direct appropriate funding to pension plans and hold the line on retirement costs? What will be the impact of Detroit’s bankruptcy process on other cities and their pension plans? Recent changes in GAAP requires states and municipalities to show unfunded pension liabilities on financial statements. Strictly Financials
  18. 18. Story Ideas 1.  2.  3.  4.  What is the financial health of pension plans in your area? (Public plans have to provide data.) Are plan administrators considering actions to modify plans? What resistance is expected? What has been the financial performance of the fund over time? Is it competitive with other plans? What is retirement pay for high paid employees?
  19. 19. Resources n  “Covering your local pension plan” SABEW Teletraining, Dec. 5, 2011 n n  Detailed tutorial by David Milstead n  Advice from Barlett and Steele winner Craig Harris of the Arizona Republic n  Overview from the National Council of State Legislatures n  Strictly Financials
  20. 20. WILL SOCIAL SECURITY BE YOUR SECURITY? Strictly Financials
  21. 21. Social Security and Medicare: The Looming Political Crisis n  Social Security (taxes paid on income up to $113,700 in 2013) n  n  n  n  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) n  n  Provides hospital insurance at age 65 and above Don’t forget to register before you turn 65! Strictly Financials
  22. 22. FAQs Regarding the SSA n  How much can I earn and still receive benefits? n  n  n  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? n  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
  23. 23. What About the Social Security Trust Fund? n  “There’s a lockbox that keeps and invests the FICA taxes you pay.” No, not really n  n  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
  24. 24. Current Status of Social Security Trust Fund (from the 2012 Social Security Trustees Report) n  In 2010, Social Security costs exceeded income from payroll taxes for the first time n  n  n  n  Recession reduced payrolls Baby boomers started to retire (we already know this – they’ve been around for 65 years) It’s estimated that by 2037 the trust fund will be exhausted and yearly SS tax revenues will fund 78% of promised benefits. 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
  25. 25. Will Social Security be Around When You Retire?” n  “I don’t count on Social Security because it will be broke when I retire.” Not True. n  n  n  n  This is a legal obligation of the U.S. Government, which it really can’t 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
  26. 26. What Can Congress Do? (Its really just a math problem with difficult political solutions.) n  Increase SS retirement age? n  n  Increase income tax on SS benefits? n  n  Currently, if your taxable income exceeds $44,000 (joint), 85% of SS benefits become taxable. Uncap the wage level for payroll taxes (set at $113,700 for 201)? n  n  Originally set at 65 in 1935, its 67 for those born after 1954 but life expectancy has dramatically increased. Medicare taxes currently are uncapped Increase the payroll tax? n  By 1.96% total as shown earlier Strictly Financials
  27. 27. What About Medicare And New Healthcare Legislation? n  n  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
  28. 28. Information about Social Security n  n  Center for Retirement Research at Boston College. List of publications at: %2520security%3bbriefs.html Strictly Financials
  29. 29. Story Ideas 1.  2.  3.  Do your readers believe that Social Security will pay them retirement benefits? Do they favor changes to the system that will insure its survival – (1) increase retirement age, (2) increase taxes, (3) increase taxable wage base? How does Social Security fit in your retirement planning?
  31. 31. How Much do you Need to be Comfortable in Retirement? n  The standard “80% Replacement Ratio” Rule of Thumb n  n  You need 80% of pre-retirement income to maintain your life style after retirement. Sources of funds for retirement n  n  Social Security – today, about $57,000/year for a married couple at full retirement age and maximum benefits Employers retirement Plans n  n  n  401-ks, defined benefit plans Your own IRAs and other tax shelters (401-ks, 457-k’s) After tax investments you have made Strictly Financials
  32. 32. Yearly Income Calculation* n  n  Assume a married couple, with one spouse having maximum social security contributions. Assume they made $122,500 just before retiring n  n  The “replacement ratio” amount is 80% or $98,000 Social Security will provide $57,000/year* *($38,000 + $19,000 = $57,000) n  n  Your shortfall is $98,000-$57,000 = $44,000 Will you be able to generate $44,000 of income from other sources? *All amounts calculated “before Income Taxes Strictly Financials
  33. 33. What Size of Nest Egg is Needed? n  n  n  As an approximation, use the “4% Rule” To generate $44,000/year requires a “nest egg” of $44,000/.04 = $1,100,000. With $1,100,000 to start, you can withdraw $44,000/year and have less than a 5% chance you will ever deplete your fund. n  This assumes your are invested in at least a 60% stock/40% bond portfolio Strictly Financials
  34. 34. A Sample Diversified Portfolio MLPs, 5% Other, 5% Allocation Large Cap Stocks, 30% Real Estate, 10% Large Cap Stocks Small Cap Stocks Int'l Stocks Bonds Real Estate MLPs Bonds, 20% Other Int'l Stocks, 15% Small Cap Stocks, 15% Strictly Financials
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  39. 39. Will Congress Address the Budget Deficit and Tax Policy n  Is the deficit a problem of too much spending or too little tax revenue? n  n  Both sides are entrenched in their positions Will Congress tackle tax reform? (it was last accomplished in 1986) n  n  Spending policies reward constituent groups Tax policies reward constituent groups and it can be hard to uncover who benefits Strictly Financials
  40. 40. CORPORATE GOVERNANCE Strictly Financials
  41. 41. What is it? n  n  Larcker – “… the collection of control mechanisms that an organization adopts to prevent or dissuade potentially selfinterested managers from engaging in activities detrimental to the welfare of shareholders and stakeholders.” Who are the stakeholders? n  n  n  n  n  Customers Suppliers Unions Media Regulators Board Community Creditors Others? Other Governance mechanisms – n  n  n  Efficient Capital Markets, Regulatory Enforcement Legal tradition Societal and cultural values Accounting standards The following slides are from: Standford GSB, CBRP-16 01/11/2011. Prepared by Larcker and Tayan. Strictly Financials
  42. 42. Three Key Corporate Governance Players n  Management – in most companies management is separate from owners (shareholders). This creates the “principal – agent” issue. n  n  Directors – are they truly independent? n  n  n  Does management they truly seek to maximize the value of the firm for the shareholder or act in their own selfinterest. Are they “inside” or “outside” Characteristics and qualifications Shareholders n  n  n  Active or Passive? Institutional or individuals? Company founder or new investor? Strictly Financials
  43. 43. What Are “Agency Costs” n  n  Agency costs are costs incurred by shareholders to monitor behavior of management: n  Inflated compensation or excessive perks n  Manipulating financial results n  Creating an “empire” rather than creating value n  Poison pills to protect job The agency problem is how to control the behavior of self-interested management. Strictly Financials
  44. 44. Three Misconceptions about Corporate Governance
  45. 45. Does The Structure of the Board Equal the Quality of the Board? n  Independent chairman Independent directors Lead independent director Board size Diversity of directors Busy boards no evidence no evidence some evidence mixed evidence mixed evidence negative n  Boards “appointed by” the CEO negative n  n  n  n  n  n  Note that it is really difficult to empirically demonstrate that any of these factors impact share value or stockholder’s returns. Strictly Financials
  46. 46. Does Regulation Improves Corporate Governance? n  n  What has been the impact of Sarbanes-Oxley (SOX) of 2002? What will be the impact of Dodd-Frank (2010)? n  Proxy access n  Say-on-pay Strictly Financials
  47. 47. Are “Best Practices” the solution? n  n  n  Larcker calls this the most destructive myth in corporate governance. We cannot prove that there are “best practices” that lead to superior outcomes and stock price performance. Corporations operate in a very complex environment – both internal and external. A large number of variables interact to affect their success or failure, so once again its very difficult to prove a relationship between governance and outcomes. Strictly Financials
  48. 48. Institutional Investors as Activist Shareholders
  49. 49. Institutions as Shareholders n  Who are Institutional Investors? n  n  n  n  n  n  Private & Public Pension funds Mutual Funds Insurance Companies Bank Trust Departments They hold about 70% of publicly traded shares. For many large companies, institutions hold more then 50% of their stock. n  Microsoft (69%), GE (55%), Intel (70%) Strictly Financials
  50. 50. Share Voting by Institutions n  Many institutions rely on “proxy advisory firms” for guidance on how to vote their shares. n  n  n  n  RiskMetrics/ISS Glass-Lewis Since many institutions are fiduciaries should they try to impose governance changes? If they do, whose interests should they pursue? Strictly Financials