Many investors in the municipal-bond market are concerned that retirement costs will eventually cripple states, particularly in Illinois and New Jersey, which also have settled SEC charges related to pension disclosures. State retirement systems have far less funds than they need to meet all their projected payouts, with the Pew study putting the combined shortfall at $915 billion as of 2012.
Instead of trying to reduce its pension obligations, Kansas wants to earn some money by borrowing at 5%, and then investing the money in its pension fund, where it thinks it can earn 8%. This would represent an arbitrage opportunity, except for the fact the the pension investments are in higher risk securities which naturally earn a risk premium. This means that the extra return that they generate are compensation for the additional risk that Kansas will incur.
Even under the best circumstances, pension bonds come with the risk that expected spreads won’t materialize. Since Oakland, Calif., sold the first pension-obligation bonds in 1985, cities and states have issued about $105 billion of the debt, the Center for Retirement Research said last year. Those deals have had returns averaging 1.5% annually since 1992, thanks to market gains following the financial crisis, the center said.
We have blogged about under-funded pensions before. They arise because the median voter, and the politicians they elect, typically do not understand or care about the problem. Refreshingly, Nashville's Mayoral candidate David Fox has raised the issue in his campaign:
...The danger of debt is probably the issue he's most passionate about: He gives the sense that the city's unfunded liabilities and debt really do keep him up at night.
"What do you think is gonna happen when our national economy, as it will do cyclically — when our national economy goes sideways for several years?" Fox asks. "We're going to see a lot of municipal bankruptcies. Because unfunded liabilities are too big, the balance sheets are way out of whack, you have way too much debt at the municipal level, and a lot of cities are going to go bankrupt. That's not gonna be an accounting adventure, that's gonna have a real bad effect on people who live in these cities."
TRUTH IN BLOGGING DISCLAIMER: I am leaning towards Fox (and his wife is a former student).
Too good to be true?
ReplyDeleteThe thought of too good to be true comes to mind, but is it? There are many ways to turn one man’s trash to another man’s treasure. We may have been looking for something in a store only to find out it has been discontinued, or that 1992 Hess truck that will finish your 90’s set. What is one to do? Customer-to-customer (C2C) is business transaction between two consumers without the use of a retailer, like you selling a Hess truck because you happen to have two 1992s. But what about the person that is making a living using E-Bay, have you ever noticed that there are sellers with thousands of transactions or are “top rated sellers”, and that these people are selling hundreds of different items as well? I am not talking about a retailer selling accessories to the new iPhone, there are many people that scour thrift stores and garage sales looking for that arbitrage opportunity. The items they can buy for a dollar and sell for more. There are even apps for that, you scan the barcode and it tells you what the product is selling for on Amazon.
Underfunded pension plans
ReplyDeleteIf one reviews the lists of critical and endangered pension plans, which are published every year by the United States Department of Labor on www.dol.gov › EBSA, would become worried of the number of public pension plans that are at risk of being left underfunded. According to articles on public pension funding, the way pension plans are managed is the main cause of pension plans becoming underfunded. The accounting management of the pension plans seems to have loopholes, aggravated by a lack of rules or jurisdiction in determining the annual required contribution to these funds (Atanasov, 2014). One of the reasons is that not making the annual required contribution by state or local governments has no immediate legal repercussions, as the payments may be postponed: it seems to be no obligation to disclose the costs associated with postponing these contributions (Atanasov, 2014). Other reasons that may cause pension plans to become underfunded are that they are not managed as to prevent downturns in the market (Wasik, 2014), or to overcome, in the long term, the low contributions of current participants (Wasik, 2014).
References:
Anatasov, I. 2014. Why public pension plans are left unfunded. http://www.publicsectorinc.org;
Wasik, J. 2014. Is Your Pension Plan Underfunded? http://www.forbes.com;
Nice. thanks, Luke
DeleteOpportunity cost is not always a number; opportunity cost can sometimes be the cost of any action, which can simply be the next best alternative of that action. According the Luke Froeb “The opportunity cost of an alternative is what you give up to pursue it”. If I have a number of alternatives to spend my Saturday night like - I can to a church social activity, I can go Bowling, I can stay home and study for my Managerial Economics Quiz, I can go out to have dinner with my friends or I can go to the movies. If I chose to go Bowling, my opportunity cost of that action is what I would have chose If I have not gone Bowling, it would be either going out to dinner with my friends or stay or stay home and study for my Managerial Economics Quiz. However, an opportunity cost only considers the next best alternative to an action not the entire set of alternatives.
ReplyDeleteHowever, when we forego something to obtain what we want, that can represent an opportunity cost. Opportunity cost does not measure all possible alternatives, just the second best one. For example: If I had not gone to Bowling, I would have studied for my Managerial Economics Quiz. The opportunity cost of going to Bowling is the 4 hours of study time lost. Also opportunity cost need to account for all difference between the choice we make and the second best alternative. For instance if I take one year leave of absence from my job paying $76,000 per year to obtain my MBA at a school with a tuition and books for $39,000 per year. My opportunity cost for my MBA studies would measured in dollars $115,000. This would include both my $39,000 paid for tuition and my $76,000 in lost wages. For us to make the best possible decisions we need to compare the benefits of anything obtain to the cost of obtaining them. We can do this through marginal analysis.
Reference:
1. Frobe, McCann, Ward and Shor (2014) Managerial Economics – A Problem Solving Approach.
2. Cassidy, Kevin (2001) New York University: Lenard, Stern School of Business: Economics Cost – The Ones That Matter.
You know what’s great about Kansas? It’s not New Jersey.
ReplyDeleteAlthough I find the proposition of borrowing at 5% and investing the borrowed funds at a rate of 8% so that the pension investments are in higher risk securities which naturally earn a risk premium to be a creative and a possible solution to the predicament in which Kansas and many other states’ municipalities find themselves, there is a key word at play here that needs to be considered – “risk”. What is the level of risk and how will it be managed? If the riskier investments end up going south, Kansas will then find itself in a worse position than they were initially.
The forward thinking of Nashville’s possible governor, Fox, is intriguing. The challenge is that Fox is offering a mindset, an opinion, a way of thinking… where, however, is the actual solution? Fox talks about improvements that need to be made with regard to infrastructure, sewer, etc… but we never really learn where the money will come from. One can assume from his propositions that he would rather take any city earnings and reinvest in support systems that currently maintain the city, rather than focus on growth. If this is the case, then it would seem as though it is a solid plan for paying down debt and firming up the foundation of the city.
Finally, there is a certain Mr. Christie who can use a bit of coaching from his peer, Mr. Fox, located about 1400 miles directly to his west. Where Fox’s thinking is a bit more pro-active, Christie’s seems to be more reactive. This approach has helped the Treasury Department to project a bit of bad news for the State of New Jersey – its two largest pension systems could begin to run out of money in a decade or less! In fact, now that states are required to apply more conservative accounting rules adopted by the national Government Accounting Standards Board, the New Jersey state government’s unfunded liability for teacher and state employee pensions went from estimated $37.3 billion as of June 30, 2013, to a more likely $83 billion when assessed on June 30, 2014.
According to a recent article in NJ Spotlight, during his first 2 years in office Chris Christie, governor of New Jersey, was able to make the first two pension payments in FY2012 and FY2013 due to cuts he made elsewhere, however, the already-budgeted third-year payment of $1.6 billion in 2013 and the fourth-year payment of $2.25 billion for 2014 were cancelled due to hardships in the state’s economy.
These moves have led to New Jersey’s bond rating being cut no less than eight times by Moody’s, S&P, and Fitch since Christie has been in office! This puts the state in quite predicament since it adds to the state’s borrowing costs for bond issues and also scares away investors and corporations. One would think that Mr. Christie would be served well by following the mindset of Mr. Fox and work to eliminate debt, while attempting devising a plan to fund the pensions that are now at risk. Oh one last thing, don’t raise tolls and thanks for all the work on the NJTP. It turned out great!
References
Magyar, Mark J. “Moody’s: New Jersey’s Pension Funds Could Run Dry in Just 10 Years.” NJ Spotlight, Web. 4 Dec. 2014
I think it’s ridiculous that Kansas wants to borrow money (with interest) in order to invest in their own program. If Kansas is already having financial difficulties then I think it would be suicide to do this knowing that the risks are very high. Kansas also needs to weigh those risks as well as determine whether or not the return on investment is higher than the interest they would be paying on the loan. I do think it’s an arbitrage opportunity even though Kansas is incurring that high risk. Kansas is exploiting the market by investing in their own pensions just to come out ahead. I’m sure there are other ways for Kansas to come out ahead or break even. They could reduce other cost such as the roads and school cost. Borrowing at a 5 percent interest rate (as small as it might sound) seems they are just incurring additional cost the state cannot afford.
ReplyDeleteReference:
Frobe, McCann, Ward and Shor (2014) Managerial Economics – A Problem Solving Approach.
Our pension funds are in desperate need of being reformed. American Express established the first pension plan in 1875.
ReplyDeleteThe average life expectancy was approximately 49 years in 1900 and in 1935 it became 60 years. In 1935 the Social Security system established that 65 was the standard age to retire. (scholarship.law)
Today, the average age of retirement is still 65 years old, while the average life expectancy is 81. People are out living their contributions to these pension plans.
Former Mayor Bloomberg stated: for every state and city dollar that goes toward pension funds reduces dollars that should be invested in our schools, public safety, job creation, roads and bridges and other critical infrastructure".
“An opportunity is created with arbitrage. Pension funds must be invested loaned out and borrowed. Eventually there will be no pensions, if we continue to do nothing. “Arbitrage opportunity arises when prices for the same product are not the same price at the same time when they should be. In theory, arbitrage is a riskless activity because traders are simply buying and selling the same amount of the same asset at the same time. For this reason, arbitrage is often referred to as "riskless profit."( www.investinganswers.com)
Failure to plan is planning to fail. There are so many people whom retired at 65 with little to no savings and will live to be well over 75 years. There are also many Americans whom are able to work just 20-25 years for an organization; you don’t need to be 65 to start collecting a pension. This allows someone to collect funds from a pension plan for 20-35 years, when it should have been 5-10 max. America needs to re-evaluate our policies and expectations of what people contribute and can received from pension plans. Canada and Australia are good examples of planning for the future.
http://scholarship.law.georgetown.edu/cgi/viewcontent.cgi?article=1049&context=legal
http://www.investinganswers.com/financial-dictionary/world-markets/arbitrage-2171
Why are Tokyo Apartment prices rising?
ReplyDeleteJapan's Prime Minister, Abe, and the Central Bank governor of Japan, Mr. Kuroda, are divided by trying to balance the need to reduce the debt compared with boosting Japan's economy per a recent article in the Economist.
One of their differences is the fiscal policy which has been loose, and which deals with the government expenditures, taxes and debt. Their primary budget deficit at 6.6% GDP, excludes interest payments on debt.
Another difference is getting rid of Japan's deflation, which the Bank of Japan has not been successful at. Even so they pushed up inflation to 2%. If deflation returns in the coming months, the bank will feel obligated to buy the bonds they sold; if inflation picks up, the Central Bank will begin tighten its monetary policy.
Advisers to the Central Bank are advising to decrease the inflation rate from 2% to 1%. They have not yet resolved the problem with prices. Per the Trading Economics website chart, Japan’s inflation rate was forecasted to increase to 2.5% in April 2015 from 2.2% in March 2015, and the consumer prices rose 2.4% this past January 2015.
Japanese are growing anxious as the two most important categories per the consumer price index are: Food (25 percent of total weight) and Housing (21 percent). The consumption tax increased from 5% to 8% in April 2014 and it is planned to increase to 10% this fall 2015.
Mr. Koruda is postponing the rise of the consumption tax to 2017 debating that Japan's economy will not be able to handle it. The first rise of the consumption tax pushed the economy back into recession, after the Central Bank actions of printing vast quantities of money to purchase bonds failed, and the forecasted structural reforms have not taken place.
Per the Economist, Japan's economy has helped exporters, but higher prices for imports have not benefited small businesses and households.
The Economist. {April 11 2015} End of the affair
,http://www.tradingeconomics.com/japan/inflation-cpi
JAPANTODAY, {Apr, 14, 2015} Yen gains after Abe's adviser says it is too low, http://www.japantoday.com/category/business/view/yen-gains-after-abes-adviser-says-it-is-too-low
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