Financial Markets in 2013: Where are the Stories?

Strictly Financials
Saturday January 5, 2013

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

Strictly Financials

Gary Trennepohl, Ph.D.

n n n n

ONEOK Chair and Presidents Council Professor of Finance Oklahoma State University Trustee, Oklahoma Teachers Retirement System Member, OSU Foundation Investment Committee

gary.trennepohl@okstate.edu

Strictly Financials

Major Economic Themes for 2013

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
Strictly Financials 4

What is the Fiscal Cliff?

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

Strictly Financials

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. However, federal, public and private debt is at historic levels we are borrowing more than is prudent. So, should we increase taxes and reduce spending in a weak economy?
Strictly Financials 6

Strictly Financials

Strictly Financials

Strictly Financials

Automatic Spending Cuts

n

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

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

Strictly Financials

10

Bush-Era Tax Cuts Expire

n

Income Tax Rates Rise

n n

Will be: 15%, 28%, 31%, 36% and 39.6%, Up from 10%, 15%, 25%, 28%, 33% and 35%. Increase from 15% to 20% Increase from 15% to ordinary income rate

Capital-Gains Rate Rises

n

Dividend Tax Rate

n

Other tax credits reduced or eliminated

Strictly Financials 11

Others
n

n n

Payroll taxes back up to 6.2% from 4.2% (This funds Social Security system). Unemployment-benefits extension expires. Medicare-payment rates to physicians drop by 27%. (Congress has repealed this requirement every year since it was passed.) New Medicare surtax of 3.8% on individuals with AGI above $200,000, on all income.
Strictly Financials 12

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

n n n n n n n n n

Discretionary-spending caps Health-care law taxes Payroll-tax cut expires Bush tax cuts for wealthy expire Bush tax cuts for others expire Tax extenders expire Extended jobless benefits expire Physician payment cut Alt. min. tax not patched Total
(The Economist, Nov 10-14, 2012)

$ 84 Most Impact 21 . 116 . 45 . 150 Impact 30 . 25 . 20 . 94 Least Impact $670

13

Strictly Financials

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.
Strictly Financials 14

Tax Breaks Under Fire and Their 2012 Costs1

n

n n n n
1

Health Care employer-provided insurance and Medicare: $201B Savings Incentives 401Ks, IRAs, definedbenefit plans: $135B Mortgage-Interest Deduction $ 84B Dividends and Capital Gains $ 93B Charitable Donations $ 40B State-Tax Deductions $ 47B
Strictly Financials 15

Laura 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. People usually form their opinion about tax policy based on their personal situation Dont tax me and dont tax thee; tax the one behind the tree! Educate readers about the public policy implications of tax policy.
Strictly Financials 16

Story Ideas:
n

Does your community have Department of Defense installations? Is your state a net giver or taker regarding federal taxes and payments? Do you live in a high-tax or low-tax state? Changes in tax laws will impact communities differently.
Strictly Financials 17

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 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). Provides hospital insurance at age 65 and above Dont forget to register before you turn 65!
Strictly Financials 19

Medicare (tax paid on total income)

n n

FAQs Regarding the SSA

n

How much can I earn and still receive benefits?

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 dont have to start drawing SS benefits.
Strictly Financials 20

Social Security Myth 1

n

Theres 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 dont 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

21

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 n

Recession reduced payrolls. Baby boomers started to retire. (We already know this theyve 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 22

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.

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%, (i.e.. .96% each for worker and employer), the 41% benefit level could be maintained to 2086.
Strictly Financials 23

Social Security Myth 2

n

I dont 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. 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 24

What Should Congress Do?

n

Increase SS retirement age?

n

Originally set at 65 in 1935, but life expectancy has dramatically increased. Currently, if your taxable income exceeds $44,000 (joint), 85% of SS benefits become taxable.

Increase income tax on SS benefits?

n

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

Medicare taxes currently are uncapped By 1.96% total as shown earlier

Strictly Financials 25

Increase the payroll tax?

n

What About Medicare And New Health-Care Legislation?

n

The real economic issue is spending on health care. 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. The real cost and impact of the Affordable Care Act is a great uncertainty.
Strictly Financials 26

Mandatory Spending Since 1962

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

80% Other Health Programs 70%

60%

Percentage of Total Outlays

50% Other Mandatory 40% Other Retirement and Disability Income Security Medicare

Medicaid

30%

20%

10%

Social Security

0%

20 1

20 1

0 20 2

20 0

20 0

19 8

19 8

19 9

19 9

19 9

19 8

19 8

19 7

19 7

19 7

19 7

19 7

19 8

19 9

19 9

Fiscal Year

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.

Source: Congressional Research Service, March 12, 2012

In an effort to reform the private insurance market and expand health insurance coverage to the 27 Strictly Financials 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

20 0

20 0

20 0

20 1

20 1

20 1

20 2

Strictly Financials

28

Information about Social Security and Medicare

n

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

Strictly Financials

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 ensure its survival (1) increase retirement age, (2) increase taxes, (3) increase taxable wage base? How does Social Security fit in your retirement planning?
Strictly Financials 30

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

Strictly Financials

31

Grabbing Headlines
n

Series by Craig Harris in the Arizona Republic, 2011,Pension Funds in Arizona Facing Bleak Future. U.S. Public Pension Plans are Different (and Not in a Good Way! Jeffrey Brown, Forbes, June 11, 2012.) New Rules may make Public Pensions Appear Weaker, Reuters.com; June 25, 2012. 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).

Strictly Financials

32

Two Principal Types Of Pension Plans

Strictly Financials

33

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 n

n n

Most public pension 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 34

Defined-Contribution Plan
n

n n

Employer assumes only obligation to pay yearly % of salary (e.g., 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 35

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
36

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

Typical Pension-Plan Sponsors

n

State or municipal employee plans (almost all are defined-benefit plans):

n n n n

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 37

Measuring Pension-Plan Health

n

Actuaries can project future plan liabilities and income key factors are:
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 (e.g., 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
n

A funding ratio of at least 80% is considered safe.

Strictly Financials 38

Strictly Financials

39

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).

Poorly funded plans will have to lower discount rate (to a municipal-bond rate) on liabilities (which makes funding ratio worse.) Teacher retirement plans are especially vulnerable to show a weaker financial position.
Strictly Financials 40

But Be Skeptical About Studies Which Predict Plan Insolvency

n

Most studies use historical aggregate data, which may not include recent plan improvements. Projections are based on many assumptions. For best information, use the yearly actuarial report, which all public plans require. Dont confuse accounting books with actual investment performance. In addition to the current funding ratio, consider the
n n

Funding horizon and its trend over the past decade. The trend in the funding ratio over the past decade.
Strictly Financials 41

States are Acting to Change their Public-Pension Plans

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

Strictly Financials

42

The Economist, June 23, 2012

Strictly Financials

43

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.
Strictly Financials 44

Strictly Financials

45

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. Bankruptcies by local governments have been one option. (States cannot use bankruptcy.) Typical choices for improving funding:
n n n

Raise retirement eligibility/age Increase state/employee contributions 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 n

Falling stock market reduced portfolio values Reduced contributions from states as they struggled to balance budgets. 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 47

Alternatives for state and local government plans

n

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?
Strictly Financials 48

Resources
n

Covering your local pension plan

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 SABEWs 2011 public pensions seminar n Overview from the National Council of State Legislatures
n
Strictly Financials 49

What about the Euro And the European Union?

Strictly Financials

50

The European Union

n n

Created by the Maastricht Treaty in 1991 Introduced the Euro () in 1999 at a value of $1.18 per 1. 16 countries now use the
n

Austria, Belgium, Cyprus, France, Finland, Germany, Greece, Ireland, Italy, Kosovo, Luxemburg, Malta, Netherlands, Portugal, Slovenia, Spain. Denmark, Norway, Sweden and the U.K. do not use the but are part of the European Union.
Strictly Financials 51

Why have a Monetary Union?

n

Advantages:
n n n

Reduces costs (dramatically) Eliminates exchange rate uncertainty Promotes trade and political cooperation Loss of monetary independence and control Tensions between rich and poor states Difficulties in maintaining unified control

Disadvantages:
n n n

Strictly Financials

52

Key Criteria for Membership

n

Ratio of Budgetary Deficit to GDP 3%

n n

U.S. is 10.64% in 2011 budget EU is 6.3% in 2010 U.S. is 94.27% in 2010 EU is 74.0% in 2010

Ratio of Gross Public Debt to GDP 60%

n n

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

Strictly Financials

53

Strictly Financials

54

So, Whats 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.

But, because most of the debt is held by European banks, the EU set up a bailout fund. What impact will the fear of a debt crisis in Europe have on the international banking system and interest rates?
Strictly Financials 55

Story Possibilities
1.

2.

3.

4.

What impact would death of the Euro have on businesses in your city? What relationship do banks in your area have with global banks? Do banks/pension funds/investors in your city or state hold foreign bonds? Do companies in your area do business with Greece, Portugal, Ireland or Spain?
Strictly Financials 56