Gary Trennepohl presents "Financial Markets in 2012" during the annual 2012 Reynolds Business Journalism Seminars, hosted by the Donald W. Reynolds National Center for Business Journalism. For more information about free training for business journalists, please visit businessjournalism.org.

1. Financial Markets in 2012:
Where are the Stories?
Strictly Financials
Jan. 5, 2012

2. Donald W. Reynolds National Center
For Business Journalism
At Arizona State University
Strictly Financials 2

3.  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
 gary.trennepohl@okstate.edu
Strictly Financials 3

4. 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
Strictly Financials 4

5. 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.”
I. WILL THE EURO SURVIVE?
Strictly Financials 5

6. A. An Historical Perspective
About Exchange Rates is Useful
Strictly Financials 6

7. 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 failures
Strictly Financials 7

8. 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

9. 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 futures
Strictly Financials 9

10. B. What about the Euro
And the European Union?
Strictly Financials 10

11. 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.
Strictly Financials 11

12. 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
Strictly Financials 12

13. 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.
Strictly Financials 13

14. Strictly Financials 14

15. 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?
Strictly Financials 15

16. 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

17. U.S. Companies And
Currency Exchange Rates

18. 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
Strictly Financials 18

19. 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.
Strictly Financials 19

20. 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?

21. 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.

22. Strictly Financials 22

23. Strictly Financials 23

24. Strictly Financials 24

25. Look for Congress to Address
Entitlement Spending to Make
Progress on the Budget Deficit
Strictly Financials 25

26. Strictly Financials 26

27. Strictly Financials 27

28. Will Social Security
Be Your Security?

29. 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!
Strictly Financials 29

30. 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.
Strictly Financials 30

31. 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.
Strictly Financials 31

32. 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.
Strictly Financials 32

33. 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.
Strictly Financials 33

34. 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
Strictly Financials 34

35. 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
Strictly Financials 35

36. 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.
Strictly Financials 36

37. 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/soci
al%2520security%3bbriefs.html
Strictly Financials 37

38. 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

39. Will the Coming Crisis
In Public Pension Plans
Affect Your Community?
Strictly Financials 39

40. 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.
Strictly Financials 40

41. 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 Deal
Pensions and Investments, August 9, 2010 , p 12.
Strictly Financials 41

42. States Making Changes to Public Employee
Pension Plans – 2009: (The Pew Center on the States)
Strictly Financials 42

43. States Making Changes to Public Employee
Pension Plans - 2010
Strictly Financials 43

44. Two Principal Types
Of Pension Plans
Strictly Financials 44

45. 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

46. 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

47. 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
* as of Sept. 30, 2009* from Pensions&Investments, Dec 28 and Feb. 8, 2010)
Strictly Financials 47

48. 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)
Strictly Financials 48

49. 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

50. Funding Levels of Public Plans*
Strictly Financials 50

51. 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

52. 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 52

53. Resources
 “Covering your local pension plan”
 SABEW Teletraining, Dec. 5, 2011
 http://sabew.org/2011/12/covering-your-
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
Strictly Financials 53