Copyright Jeremy Gold 2010 4(GS): Financial Economics - Simple Market Ideas Applied to Public Pension Plans Jeremy Gold Middle Atlantic Actuarial Club.

Copyright Jeremy Gold 2010

4(GS): Financial Economics - Simple Market Ideas Applied to Public Pension Plans

Jeremy Gold

Middle Atlantic Actuarial Club

Baltimore, MD

October 7, 2010

Jeremy Gold Pensions

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• History

• Principles

• Implications

Outline


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Something for All to Hate

• Financial economics is the science of financial markets and institutions

• You can’t hate a science but you can hate its implications – and its messenger

• Implications may be negative for

– today’s taxpayers

– today’s elected officials

– employees


4

Pop Quiz


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Pop Quiz

• How much does a $1000 bike cost?


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Pop Quiz

$1000


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Pop Quiz

• How much does it cost if I pay cash from my latest pay check?


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Pop Quiz

$1000


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Pop Quiz

• How much does it cost if I take money from my savings account?


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Pop Quiz

$1000


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Pop Quiz

• What if I charge it on a credit card?


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Pop Quiz

$1000


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Pop Quiz

• How much if I sell stocks?


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Pop Quiz

$1000


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The Lesson

• No matter how I finance it, the cost of a $1000 bike is $1000!


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Extra Credit

• How much do the following cost?

– $1000 worth of stock

– $1000 worth of bonds


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• History

• Principles

• Implications

Outline


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Financial EconomicsHistory

– major impact on financial markets in 70’s 80’s and beyond

Financial economics explodes on the financial world

– Academic genius from 1950’s to 1970’s leads to


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• Three major branches –

– Asset pricing/portfolio selection

• e.g., the Capital Asset Pricing Model

RiskReturn


20



– Asset pricing

– Financial mathematics• applied to options, futures, swaps

• e.g. Black-Scholes

z

x

dxez2)(

21

)(


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– Asset pricing

– Financial mathematics

– Modern corporate finance

• ignored by most pension professionals including actuaries


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• History

• Principles

– Financial economics

– Modern finance

– Pension finance

• Implications

Outline


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Financial EconomicsPrinciples

– Financial economics analyzes financial systems

– All three branches rely on strong assumptions about

• Transparency

• Rationality

• Absence of arbitrage


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• Transparency– Decision makers have inexpensive

access to all pertinent information– They can see through institutional

structures to the underlying values


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• Rationality– People behave rationally in their

own interests– Transparency and rationality imply

efficiency – good decisions at low cost


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• Absence of arbitrage– No free lunches


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• We also study the limitations of rationality, transparency, arbitrage


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• History

• Principles


– Modern finance

– Pension finance

• Implications

Outline


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Modern FinancePrinciples

• Financial institutions are “pass-through” entities

– Their risks and returns pass through to constituents (human beings)• Shareholders/Taxpayers

• Lenders

• Employees

• Suppliers

• Customers

• Risks and rewards are borne by these individuals– Institutions just pass the real economic impacts on to others


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Modern FinancePass-Throughs

Humans

Institutions

Contracts & Cash Flows


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Humans

Institutions



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Humans

Institutions



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Humans

Institutions



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• Shareholders own the corporate assets and owe the liabilities

• Taxpayers own the locality’s assets and owe the liabilities


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• History

• Principles


– Modern finance

– Pension finance

• Implications

Outline


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Pension FinanceModern Finance Applied to Pension Plans

• Total employee compensation includes $ today and a contract for $ tomorrow

+


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Pension Finance

• Ideally the taxpayers pay for both forms of compensation today – at the same time that the employees are serving the taxpayers

+


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Pension Finance

• The contract is really an annuity and it could be bought today from an insurance company


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Pension Finance

• Taxpayers would bear little risk and would be indifferent between paying current $ and promising future pensions


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Pension Finance

• And if each generation of taxpayers paid for the annuities as they were promised, current and future taxpayers would be in balance too


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Pension Finance

• The owners of the insurance company would be taking some mortality risk and some investment risk

• And would expect a profit in return


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Pension Finance

• But the insurer would not recognize the profit immediately

• Profits would emerge if and when the risks were gone


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Pension Finance

• Remember the $1000 bicycle? How much does a $100,000 annuity cost?

$1000 $100,000


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Pension Finance

• Instead of buying the annuity, the taxpayers could run their own insurance company


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Pension Finance

• They would set aside the value of the annuity and, like the insurer, invest in matching bonds

• Like the insurer, some of the set aside would represent a safety margin

• Over time, the safety margin would be released to taxpayers


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Pension Finance

• But the release would go to future taxpayers

• It is the future taxpayers who really bear the risk

• If the investment or mortality experience goes badly, they will have to pay


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Pension Finance

• Financial economists would say:

– today’s taxpayers were buying annuities

– tomorrow’s taxpayers were selling annuities


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Pension Finance

• Financial economists would say:

– The rewards for taking the risks belong to the future taxpayers


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Pension Finance

• Over time the taxpayer’s do-it-yourself insurance company will build up a lot of bond assets that won’t be needed for a long time


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Pension Finance

• And someone will say:

– We are long-term investors

– Stocks usually beat bonds over the long term

– Why don’t we put some of our money in stocks?


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Pension Finance

• Until that moment

– Taxpayers were running an insurance business with as little risk as possible

– Now they are upping their bets


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Pension Finance

• Compared to the insurance company

– They are selling bonds and

– Buying stocks


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Pension Finance

• Financial economists say that selling bonds is the same as borrowing

– More money today

– Less money tomorrow


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Pension Finance

• So the taxpayer insurance company is borrowing to invest in stocks

– Buying on margin

– We know that buying on margin is risky

– Who is bearing that risk?

– Same as before – future taxpayers


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Pension Finance

• Who should get the rewards?


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Pension Finance

• When?– After the risks have been taken


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• History

• Principles


– Modern finance

– Pension finance

• Implications

Outline


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Implications

• How does the present system work?

– Under today’s rules

• Actuaries and accountants are required to front load the rewards from taking risk

• Before the risks are taken

– $100,000 annuity is marked down to $70,000


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Implications

• Future taxpayers should complain

– They take the risk

– Today’s taxpayers take the rewards

• For crying out loud!


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Implications

• Who speaks for future taxpayers

– I do

– And so we’ve come full circle

• Now we know why you may all want to hate me


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Implications

• Who should hate me first?

– Today’s taxpayers because

• I am saying you should pay more today for the promises you are making

• You cannot take the rewards when your children are taking the risks


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Implications


– Today’s elected officials because

• You will have to give the bad news to your taxpayers


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Implications


– Employees because

• Once taxpayers and elected officials realize how much those annuities really cost

• They will have to promise smaller benefits


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Implications

• For today’s taxpayers and elected officials

– Financial economics looks like a bogeyman

• For tomorrow’s taxpayers

– Today’s practice is the bogeyman and

– Financial economics is the benefactor


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Implications

For crying out loud!


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Restricted Usage

• Copyright Jeremy Gold 2010

• Please note that this document is not publicly available; it is available to attendees at the October 7, 2010 MAAC Conference. It may be shared with others in your organization on an educational basis. It may not be used for commercial purposes or shared outside your firm without permission.

• If you wish to use it for another purpose, please contact Jeremy Gold [email protected].

Copyright Jeremy Gold 2010

4(GS): Financial Economics - Simple Market Ideas Applied to Public Pension Plans

Jeremy Gold

Middle Atlantic Actuarial Club

Baltimore, MD

October 7, 2010

Copyright Jeremy Gold 2010 4(GS): Financial Economics - Simple Market Ideas Applied to Public Pension Plans Jeremy Gold Middle Atlantic Actuarial Club.

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