financial markets in 2013 by gary trennepohl

Financial Markets in 2013: Where are the Stories?

Strictly Financials

Saturday January 5, 2013

Strictly Financials 2

Donald W. Reynolds National Center for Business Journalism at Arizona State University


n  Gary Trennepohl, Ph.D. n  ONEOK Chair and President’s Council Professor of Finance n  Oklahoma State University n  Trustee, Oklahoma Teachers Retirement System n  Member, OSU Foundation Investment Committee

n  [email protected]

THE EVOLVING STORY OF “THE FINANCIAL CLIFF” AND REVISING THE U.S. TAX CODE SOCIAL SECURITY AND MEDICARE HOW UNDERFUNDED ARE PUBLIC WORKERS’ PENSIONS? SURVIVAL OF THE “EURO” AND THE EUROZONE

Major Economic Themes for 2013


What is the “Fiscal Cliff”?

n  The Mix of Expiring Tax Cuts and Spending Reductions that, if we go over the cliff, could lead to a “double dip” recession.


Why Something Must Be Done

n  The economy is weak, so any reduction in demand it is feared may lead to a “double-dip” recession.

n  However, federal, public and private debt is at historic levels – we are borrowing more than is prudent.

n  So, should we increase taxes and reduce spending in a weak economy?


Automatic Spending Cuts

n  Directed reductions that begin on January 2, 2013, of $1.2 trillion over 10 years.

n  Federal spending cuts: n  Defense $55bn in 2013 (a 10% cut to every program.) n  Other - $55bn (an 8% average to every program.)


Bush-Era Tax Cuts Expire

n  Income Tax Rates Rise n  Will be: 15%, 28%, 31%, 36% and 39.6%, n  Up from 10%, 15%, 25%, 28%, 33% and 35%.

n  Capital-Gains Rate Rises– n  Increase from 15% to 20%

n  Dividend Tax Rate – n  Increase from 15% to ordinary income rate

n  Other tax credits reduced or eliminated


Others

n  Payroll taxes back up to 6.2% from 4.2% (This funds Social Security system).

n  Unemployment-benefits extension expires. n  Medicare-payment rates to physicians drop by

27%. (Congress has repealed this requirement every year since it was passed.)

n  New Medicare surtax of 3.8% on individuals with AGI above $200,000, on all income.


Potential Calendar-Year Fiscal Impact, 2013 (in $bn)*

n  Discretionary-spending caps $ 84 Most Impact n  Health-care law taxes 21 . n  Payroll-tax cut expires 116 . n  Bush tax cuts for “wealthy” expire 45 . n  Bush tax cuts for others expire 150 Impact n  Tax extenders expire 30 . n  Extended jobless benefits expire 25 . n  Physician payment cut 20 . n  Alt. min. tax not patched 94 Least Impact

Total $670 Strictly Financials 13 (“The Economist, Nov 10-14, 2012)

MAKING SENSE OF THE TAX ISSUES

Congress also will be considering a major tax overhaul. Here are some “tax expenditures” that have been mentioned for reduction or elimination.


“Tax Breaks Under Fire” and Their 2012 Costs1

n  Health Care – employer-provided insurance and Medicare: $201B

n  Savings Incentives – 401Ks, IRAs, defined-benefit plans: $135B

n  Mortgage-Interest Deduction $ 84B n  Dividends and Capital Gains $ 93B n  Charitable Donations $ 40B n  State-Tax Deductions $ 47B


1Laura Saunders, WSJ, Weekend Edition, Nov 8-9, 2012

Tips for Following this Story

n  Be careful of your emotions versus the “facts” of the stories.

n  People usually form their opinion about tax policy based on their personal situation – “Don’t tax me and don’t tax thee; tax the one behind the tree!”

n  Educate readers about the public policy implications of tax policy.


Story Ideas:

n  Does your community have Department of Defense installations?

n  Is your state a net “giver” or “taker” regarding federal taxes and payments?

n  Do you live in a high-tax or low-tax state? – Changes in tax laws will impact communities differently.


WILL SOCIAL SECURITY AND MEDICARE BE YOUR SECURITY?


Social Security and Medicare: The Looming Political Crisis n  Social Security (taxes paid on income up to

$113,700 in 2013). n  Provides retirement benefits for a worker and his/her spouse

to the second death n  Provides disability benefits to injured workers regardless of

age n  Provides survivor benefits to widows and eligible children to

age 19 (or 22).

n  Medicare (tax paid on total income) n  Provides hospital insurance at age 65 and above n  Don’t forget to register before you turn 65!


FAQs Regarding the SSA

n  How much can I earn and still receive benefits? n  After reaching full retirement age (FRA), your SS benefits

will not be reduced, but… n  If your income is over $44,000 (joint), 85% of benefits will

be taxable.

n  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.


Social Security Myth 1 n  “There’s a lockbox that keeps and invests the

FICA taxes you pay.” No, not really 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.

n  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.

Current Status of Social Security Trust Fund (from the 2011 Social Security Trustees Report)

n  In 2010, Social Security costs exceeded income from payroll taxes for the first time. n  Recession reduced payrolls. n  Baby boomers started to retire. (We already know this –

they’ve been around for 65 years.)

n  After 2012-14, costs will exceed income, so interest payments from trust fund will be needed to fund payments.

n  After 2022, taxes and interest will be insufficient so the trust fund corpus will have to be used to fund benefits.


What About the Trust Fund?

n  In 2036, the trust fund will be exhausted. n  But, yearly payroll taxes could still pay about 75% of current

benefits.

n  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.

n  If payroll taxes immediately were raised by 1.92%, (i.e.. .96% each for worker and employer), the 41% benefit level could be maintained to 2086.



Social Security Myth 2

n  “I don’t count on Social Security because it will be broke when I retire.” Not True. n  This is a legal obligation of the U.S. government,

which it really cannot choose not to pay. n  Do you really think the government can renege on

its promise to pay your benefits that you have already paid for?

n  What if your employer decided it was not going to pay your retirement benefits that you had been promised?

n  A politically explosive issue


What Should Congress Do?

n  Increase SS retirement age? n  Originally set at 65 in 1935, but life expectancy has

dramatically increased.

n  Increase income tax on SS benefits? n  Currently, if your taxable income exceeds $44,000 (joint),

85% of SS benefits become taxable.

n  Uncap the wage level for payroll taxes (set at $113,700 for 2013)? n  Medicare taxes currently are uncapped

n  Increase the payroll tax? n  By 1.96% total as shown earlier


What About Medicare And New Health-Care Legislation?

n  The real economic issue is spending on health care.

n  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.

n  The real cost and impact of the “Affordable Care Act” is a great uncertainty.


Mandatory Spending Since 1962

Congressional Research Service 10

Figure 2. Components of Mandatory Spending As a Percentage of Federal Spending (FY1970-FY2022)

0%

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Fiscal Year

Perc

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Social Security

Medicare

Medicaid

Income Security

Other Retirement and Disability

Other Mandatory

Other Health Programs

Source: Offsetting receipts are excluded. CRS calculations based on data from CBO, Historical Tables and Budget Projections. CBO baseline projections depicted to the right of the vertical line.

Notes: CBO added the category “Other Health Programs” to its Budget Projections data following the enactment of PPACA and HCERA. This category includes Health Insurance Subsidies, Exchanges, and Related Spending, MERHCF, CHIP, and Other health spending. Prior to PPACA and HCERA, MERHCF and CHIP were included in the “Other Mandatory” category.

In an effort to reform the private insurance market and expand health insurance coverage to the uninsured as federal spending on health care increases, the Patient Protection and Affordable Care Act (PPACA; P.L. 111-148) and the Health Care and Education Reconciliation Act of 2010 (HCERA; P.L. 111-152) were signed into law on March 23 and March 30, 2010, respectively.13 Among other provisions, this legislation established a mandate for most U.S. residents to obtain health insurance, set up insurance exchanges, expanded Medicaid, and imposed various tax code changes. As a result of this legislation, mandatory federal outlays for health programs are projected by CBO to increase (see the “Other Health Programs” category in Figure 2) relative to what they were prior to the enactment of this legislation.14 Revenue increases are projected by CBO to offset the additional mandatory outlays.

13 For more information on PPACA and HCERA, see http://www.crs.gov/Pages/subissue.aspx?cliid=3746&parentid=13. 14 CBO, The Budget and Economic Outlook: An Update, Table 1-4, August 2010.

Source: Congressional Research Service, March 12, 2012


Information about Social Security and Medicare

n  Center for Retirement Research at Boston College. http://crr.bc.edu/

n  List of publications at: http://crr.bc.edu/social_security/social%2520security%3bbriefs.html

Story Ideas

1.  Do your readers believe that Social Security will pay them retirement benefits?

2.  Do they favor changes to the system that will ensure its survival – (1) increase retirement age, (2) increase taxes, (3) increase taxable wage base?

3.  How does Social Security fit in your retirement planning?


WILL THE COMING CRISIS IN PUBLIC PENSION PLANS AFFECT YOUR COMMUNITY?


Grabbing Headlines

n  Series by Craig Harris in the Arizona Republic, 2011,”Pension Funds in Arizona Facing Bleak Future”.

n  “U.S. Public Pension Plans are Different (and Not in a Good Way!” Jeffrey Brown, Forbes, June 11, 2012.)

n  “New Rules may make Public Pensions Appear Weaker,” Reuters.com; June 25, 2012.

n  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).


Two Principal Types Of Pension Plans


Defined-Benefit Plans

n  Employer assumes obligation to pay retirement benefits defined by formula.

n  Retirement benefits determined by a calculation:

n  e.g. = (years of service*2%*avg. 3 yrs. of highest salary)

n  Most public pension plans are of this type. n  Market risk is carried by the state sponsor, and the

investments are professionally managed. n  No asset available to transfer to heirs. n  $4,357 billion of assets in DB plans (as of Sept. 30, 2009)


Defined-Contribution Plan

n  Employer assumes only obligation to pay yearly % of salary (e.g., 10%) into employee-selected investment vehicle (think 401-k).

n  Individual bears the market risk and is responsible for selecting investment vehicles.

n  Retirement benefits determined by performance of investment choices.

n  Most newer corporate plans are of this type. n  Value of assets becomes part of estate that can be

transferred to heirs n  $1,720 billion of assets in DC plans (as of Sept. 30, 2009)


Ten Largest Defined-Benefit Funds*


$0 $50 $100 $150 $200 $250

Calif. Public Emp.Calif. State Teachers

NY State CommonFla. State Board

NY City RetirementTexas Teachers

Gen. MotorsNY State Teachers

Wisc. Investment Brd.State of New Jersey

Total Assets in Billions of $

* as of Sept. 30, 2009,* from Pensions & Investments, Dec. 28 and Feb. 8, 2010)

Typical Pension-Plan Sponsors

n  State or municipal employee plans (almost all are defined-benefit plans): n  Teachers (K-12, community colleges, universities) n  State employees n  Firefighters and police n  Judges

n  Local union plans (usually defined-benefit plans)

n  Corporate plans (most have converted to defined-contribution plans)


Measuring Pension-Plan Health

n  Actuaries can project future plan liabilities and income – key factors are: n  Workforce demographics n  Rate-of-return assumptions n  Mortality rates – and we are living longer n  Size of investment portfolio n  COLAs – “cost of living allowances (e.g., 2% a year)

n  The “present value” of projected pension payments and income to the plan is used to calculate the “funding ratio”: $ projected payments/$ income n  A funding ratio of at least 80% is considered “safe.”


GASB Changes May Make Public Plans Look Weaker

n  Major changes to be phased in starting June 2013: n  Plan sponsor (e.g., state or school district) must

show pension liability on balance sheet – (previously shown as a footnote to financial statements).

n  Poorly funded plans will have to lower discount rate (to a municipal-bond rate) on liabilities (which makes funding ratio worse.)

n  Teacher retirement plans are especially vulnerable to show a weaker financial position.


But Be Skeptical About Studies Which Predict Plan Insolvency

n  Most studies use historical aggregate data, which may not include recent plan improvements.

n  Projections are based on many assumptions. For best information, use the yearly actuarial report, which all public plans require.

n  Don’t confuse accounting “books” with actual investment performance.

n  In addition to the current “funding ratio,” consider the n  “Funding horizon” and its trend over the past decade. n  The trend in the funding ratio over the past decade.


States are Acting to Change their Public-Pension Plans

Yes, there is a problem that should be addressed sooner rather than later.



The Economist, June 23, 2012

Unfortunately, the Funding Gap Continues to Widen

The Funding Gap is an actuarially determined value calculated as the ratio of the “present value of promised benefits”/”present value of assets.”


What Can Be Done to Shore Up Public Pensions?

n  Changing payouts for current employees is legally difficult to impossible, so states look to make changes for new employees.

n  Bankruptcies by local governments have been one option. (States cannot use bankruptcy.)

n  Typical choices for improving funding: n  Raise retirement eligibility/age n  Increase state/employee contributions n  Replace defined-benefit with defined-contribution

plan – a costly action for most plans. Strictly Financials 46

What the Future Holds

n  In 2008, most plans were funded at over 80%, but by 2011, only 35% were. n  Falling stock market reduced portfolio values n  Reduced contributions from states as they struggled to

balance budgets.

n  Alternatives for state and local government plans n  CA, IL, NJ may need to increase contributions to 8-12% of

state budgets to keep plans solvent. n  Most states need to increase contributions an additional 2%

of state budget to get funding up to 80%. n  Experiences of Minnesota and Colorado to change plan

benefits.


Story Ideas

1.  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 48

Resources

n  “Covering your local pension plan” n  SABEW Teletraining, Dec. 5, 2011 n  Detailed tutorial by David Milstead n  Archived webinar with Barlett and Steele

winner Craig Harris of The Arizona Republic n  Archived resources at NewsU from

SABEW’s 2011 public pensions seminar n  Overview from the National Council of

State Legislatures Strictly Financials 49

What about the Euro And the European Union?


The European Union

n  Created by the Maastricht Treaty in 1991 n  Introduced the Euro (€) in 1999 at a value of

$1.18 per €1. n  16 countries now use the €

n  Austria, Belgium, Cyprus, France, Finland, Germany, Greece, Ireland, Italy, Kosovo, Luxemburg, Malta, Netherlands, Portugal, Slovenia, Spain.

n  Denmark, Norway, Sweden and the U.K. do not use the € but are part of the European Union.


Why have a Monetary Union?

n  Advantages: n  Reduces costs (dramatically) n  Eliminates exchange rate uncertainty n  Promotes trade and political cooperation

n  Disadvantages: n  Loss of monetary independence and control n  Tensions between “rich” and “poor” states n  Difficulties in maintaining unified control


Key Criteria for Membership

n  Ratio of Budgetary Deficit to GDP ≤ 3% n  U.S. is 10.64% in 2011 budget n  EU is 6.3% in 2010

n  Ratio of Gross Public Debt to GDP ≤ 60% n  U.S. is 94.27% in 2010 n  EU is 74.0% in 2010

n  But, most members violate these measures and have done so through time.


So, What’s the Problem?

n  Sovereign default is possible. n  Greece, Ireland, Portugal and Spain may be

unable to repay or refund debt as it comes due.

n  But, because most of the debt is held by European banks, the EU set up a bailout fund.

n  What impact will the fear of a debt crisis in Europe have on the international banking system and interest rates?


Story Possibilities

1.  What impact would death of the Euro have on businesses in your city?

2.  What relationship do banks in your area have with global banks?

3.  Do banks/pension funds/investors in your city or state hold foreign bonds?

4.  Do companies in your area do business with Greece, Portugal, Ireland or Spain?


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