Financial Markets in 2012 by Gary Trennepohl

Financial Markets in 2012:

Where are the Stories?

Strictly Financials

Jan. 5, 2012

Strictly Financials 2

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


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

[email protected]

mailto:[email protected]


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

I. WILL THE EURO SURVIVE?

The Economist, Nov. 26, 2011, asks: “Is this Really the End? Unless Germany and the ECB move quickly, the single currency’s collapse is looming.”


A. An Historical Perspective About Exchange Rates is Useful


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 failuresStrictly 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

futuresStrictly Financials 9

B. What about the EuroAnd the European Union?


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.


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


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.



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?


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 And Currency Exchange Rates

Importers, Exporters And 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


U.S. Multinationals That Own 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.


Story Ideas

1. 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 Election

1. 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 Address Entitlement Spending to Make Progress on the Budget Deficit




Will Social Security Be 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!


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.


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.

Current Status of Social Security Trust 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.


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.



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


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


What About Medicare And New 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.


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/social%2520security%3bbriefs.html

http://crr.bc.edu/

http://crr.bc.edu/social_security/social%20security;briefs.html

http://crr.bc.edu/social_security/social%20security;briefs.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 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 Crisis In Public Pension Plans Affect Your Community?


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.


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.

States Making Changes to Public Employee Pension Plans – 2009: (The Pew Center on the States)


States Making Changes to Public Employee Pension Plans - 2010


Two Principal Types Of Pension Plans


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*


$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 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)


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*


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 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?


Resources “Covering your local pension plan”

SABEW Teletraining, Dec. 5, 2011 http://sabew.org/2011/12/covering-yo

ur-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


http://sabew.org/2011/12/covering-your-local-pension-plan/

http://sabew.org/2011/12/covering-your-local-pension-plan/

Career

Financial Markets in 2012 by Gary Trennepohl