Financial Markets in 2014: Story Projects

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Jan. 5, 2014

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

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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  gary.trennepohl@okstate.edu

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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

PUBLIC PENSION PLANS – IS THERE A COMING CRISIS IN YOUR COMMUNITY?

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Ten “Best” and “Worst” States for Pension Funding*

n  The Best: 1.  Wisconsin 99.95% 2.  South Dakota 96.3% 3.  North Carolina 95.3% 4.  Washington 93.7% 5.  New York 92.7% 6.  Tennessee 91.5% 7.  Delaware 90.7% 8.  Florida 86.7% 9.  Wyoming 85.6%

n  The Worst: 1.  Illinois 43.3% 2.  Kentucky 53.4% 3.  Connecticut 55.0% 4.  Louisiana 56.2% 5.  New Hampshire 57.4% 6.  Hawaii/RI 59.2% 7.  Kansas 59.2% 8.  Colorado 60.0% 9.  Alaska 61.9%

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*Tinkadvisor.com; Sept. 9, 2013: Based on Funded ratio %

Ten “Best” and “Worst” Cities for Pension Funding*

n  The Best: 1.  Vancouver, WA 2.  Lincoln, NE 3.  Portland, Maine 4.  Milwaukee, WI/Cheyenne, WY 5.  Knoxville, TN 6.  Dover, DL 7.  Chattanooga, TN / Montpelier,

VT 8.  Charlotte, NC / Greenwich CN

n  The Worst: 1.  Little Rock, AR 2.  Chicago, IL 3.  Aurora, IL 4.  Charleston, WV 5.  Reno, NV 6.  Springfield MA 7.  Bakersfield, CA 8.  Stockton, CA 9.  Saginaw, MI 10.  Portland, OR

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*Thinkadvisor.com; Nov. 4, 2013: Based on pension costs as a % of tax revenues

Two Principal Types Of Pension Plans

Defined Benefit Plans (eg. most public plans) Defined Contribution Plans (eg. 401Ks)

Defined Benefit Plans n  Employer assumes obligation to pay retirement

benefits defined by formula. n  Retirement benefits determined by a

calculation: n  eg. = (years service*2%*avg. 3 yr highest salary)

n  Market risk is carried by the state sponsor n  The investments are professionally managed. n  No asset available to transfer to heirs. n  Most public pension plans are of this type

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Defined Contribution Plan n  Employer only assumes obligation to pay yearly % of

salary (eg. 6%) 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

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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) also called Taft-Hartley plans.

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

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Actuaries are hired to evaluate plans each year – they love it! n  They 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 (eg. 2% a year)

n  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.

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Two Measures of Pension Plan Health n  The “Funded Ratio”

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”.

n  Much controversy the past five years over the rate used to calculate the present value of the liabilities for public plans.

n  The “Funding Period” n  Number of years under current funding assumptions, it will

take for the plan to reach fully funded status n  A plan currently fully funded will have a funding period of 1

year, while a poorly funded plan could have a period of infinity.

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Vested Interests Will Always Argue Their Plan is the “Best”, But …

n  Either plan will work if it is properly funded and the participants are educated about pension “finance”.

n  Typically, public DB plans are under funded because governments don’t contribute the ARC each year, or add benefits without funding them.

n  DC plans may not produce sufficient retirement income because yearly contributions are too small or investment choices are poor.

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Comparison of DB and DC Plans

n  Portability between employers: n  DC plan assets are portable and belong to the

recipient. n  DB plans ARE NOT. They were designed for the

career employee.

n  Investment Management and Performance n  DC plans: Employees must make their own

investment decisions n  DB plans: Assets are professional managed

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Comparisons (cont) n  Market and Retirement Date Risk:

n  DC plan: Employees bear all risk n  DB plan: No market or retirement date risk

n  Outliving your Retirement Investments n  DC plan: Employee bears total longevity risk n  DB plan: No longevity risk; funding is certain.

n  Costs: n  DC plan: Typically higher cost per account n  DB plan: Lower costs per account

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What the Future Holds n  As the stock market causes funded ratios to improve,

will governments “underfund” pension plans to meet other budget obligations?

n  Do politicians have the will to direct appropriate funding to pension plans and hold the line on retirement costs?

n  What will be the impact of Detroit’s bankruptcy process on other cities and their pension plans?

n  Recent changes in GAAP requires states and municipalities to show unfunded pension liabilities on financial statements.

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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 n  “Covering your local pension plan”

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

local-pension-plan/ 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

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WILL SOCIAL SECURITY BE YOUR SECURITY?

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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!

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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.

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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  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 2012 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  It’s estimated that by 2037 the trust fund will be exhausted and yearly SS tax revenues will fund 78% of promised benefits.

n  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.

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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  This is a legal obligation of the U.S. Government,

which it really can’t 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

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What Can Congress Do? (Its really just a math problem with difficult political solutions.)

n  Increase SS retirement age? n  Originally set at 65 in 1935, its 67 for those born after 1954

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 201)? n  Medicare taxes currently are uncapped

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

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What About Medicare And New Healthcare Legislation?

n  The real economic issue is spending on healthcare.

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.

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Information about Social Security

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 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?

PREPARING FINANCIALLY FOR RETIREMENT – HOW’S YOUR 401K?

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How Much do you Need to be Comfortable in Retirement?

n  The standard “80% Replacement Ratio” Rule of Thumb n  You need 80% of pre-retirement income to maintain your

life style after retirement.

n  Sources of funds for retirement n  Social Security – today, about $57,000/year for a married

couple at full retirement age and maximum benefits n  Employers retirement Plans

n  401-ks, defined benefit plans

n  Your own IRAs and other tax shelters (401-ks, 457-k’s) n  After tax investments you have made

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Yearly Income Calculation*

n  Assume a married couple, with one spouse having maximum social security contributions.

n  Assume they made $122,500 just before retiring n  The “replacement ratio” amount is 80% or $98,000

n  Social Security will provide $57,000/year* *($38,000 + $19,000 = $57,000)

n  Your shortfall is $98,000-$57,000 = $44,000 n  Will you be able to generate $44,000 of income from

other sources?

*All amounts calculated “before Income Taxes Strictly Financials

What Size of Nest Egg is Needed?

n  As an approximation, use the “4% Rule” n  To generate $44,000/year requires a “nest

egg” of $44,000/.04 = $1,100,000. n  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

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A Sample Diversified Portfolio

Large Cap Stocks, 30%

Small Cap Stocks, 15% Int'l Stocks,

15%

Bonds, 20%

Real Estate, 10%

MLPs, 5% Other, 5% Allocation

Large Cap Stocks Small Cap Stocks Int'l Stocks Bonds Real Estate MLPs Other

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ISSUES REGARDING THE U.S. BUDGET AND TAX POLICY

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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  Both sides are entrenched in their positions

n  Will Congress tackle tax reform? (it was last accomplished in 1986) n  Spending policies reward constituent groups n  Tax policies reward constituent groups and it can

be hard to uncover who benefits

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CORPORATE GOVERNANCE

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What is it? n  Larcker – “… the collection of control mechanisms that an

organization adopts to prevent or dissuade potentially self-interested managers from engaging in activities detrimental to the welfare of shareholders and stakeholders.”

n  Who are the stakeholders? n  Customers Regulators n  Suppliers Board n  Unions Community n  Media Creditors Others?

n  Other Governance mechanisms – n  Efficient Capital Markets, Societal and cultural values n  Regulatory Enforcement Accounting standards n  Legal tradition

The following slides are from: Standford GSB, CBRP-16 01/11/2011. Prepared by Larcker and Tayan.

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Three Key Corporate Governance Players n  Management – in most companies management is

separate from owners (shareholders). This creates the “principal – agent” issue. n  Does management they truly seek to maximize the value

of the firm for the shareholder or act in their own self-interest.

n  Directors – are they truly independent? n  Are they “inside” or “outside” n  Characteristics and qualifications

n  Shareholders n  Active or Passive? n  Institutional or individuals? n  Company founder or new investor?

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What Are “Agency Costs”

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

n  The agency problem is how to control the behavior of self-interested management.

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Three Misconceptions about Corporate Governance

Does The Structure of the Board Equal the Quality of the Board?

n  Independent chairman no evidence n  Independent directors no evidence n  Lead independent director some evidence n  Board size mixed evidence n  Diversity of directors mixed evidence n  Busy boards negative

n  Boards “appointed by” the CEO negative

n  Note that it is really difficult to empirically demonstrate that any of these factors impact share value or stockholder’s returns.

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Does Regulation Improves Corporate Governance?

n  What has been the impact of Sarbanes-Oxley (SOX) of 2002?

n  What will be the impact of Dodd-Frank (2010)? n  Proxy access n  Say-on-pay

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Are “Best Practices” the solution?

n  Larcker calls this the most destructive myth in corporate governance.

n  We cannot prove that there are “best practices” that lead to superior outcomes and stock price performance.

n  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.

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Institutional Investors as Activist Shareholders

Institutions as Shareholders n  Who are Institutional Investors?

n  Private & Public Pension funds n  Mutual Funds n  Insurance Companies n  Bank Trust Departments

n  They hold about 70% of publicly traded shares.

n  For many large companies, institutions hold more then 50% of their stock. n  Microsoft (69%), GE (55%), Intel (70%)

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Share Voting by Institutions

n  Many institutions rely on “proxy advisory firms” for guidance on how to vote their shares. n  RiskMetrics/ISS n  Glass-Lewis

n  Since many institutions are fiduciaries should they try to impose governance changes?

n  If they do, whose interests should they pursue?

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