1. 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

2. Jeremy Gold Pensions 2 History Principles Implications Outline

3. Jeremy Gold Pensions 3 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. Jeremy Gold Pensions 4 Pop Quiz

5. Jeremy Gold Pensions 5 Pop Quiz How much does a $1000 bike cost?

6. Jeremy Gold Pensions 6 Pop Quiz $1000

7. Jeremy Gold Pensions 7 Pop Quiz How much does it cost if I pay cash from my latest pay check?

8. Jeremy Gold Pensions 8 Pop Quiz $1000

9. Jeremy Gold Pensions 9 Pop Quiz How much does it cost if I take money from my savings account?

10. Jeremy Gold Pensions 10 Pop Quiz $1000

11. Jeremy Gold Pensions 11 Pop Quiz What if I charge it on a credit card?

12. Jeremy Gold Pensions 12 Pop Quiz $1000

13. Jeremy Gold Pensions 13 Pop Quiz How much if I sell stocks?

14. Jeremy Gold Pensions 14 Pop Quiz $1000

15. Jeremy Gold Pensions 15 The Lesson No matter how I finance it, the cost of a $1000 bike is $1000!

16. Jeremy Gold Pensions 16 Extra Credit How much do the following cost? –$1000 worth of stock –$1000 worth of bonds

17. Jeremy Gold Pensions 17 History Principles Implications Outline

18. Jeremy Gold Pensions 18 Financial Economics History –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

19. Jeremy Gold Pensions 19 Financial Economics History Three major branches – –Asset pricing/portfolio selection e.g., the Capital Asset Pricing Model

20. Jeremy Gold Pensions 20 Financial Economics History Three major branches – –Asset pricing –Financial mathematics applied to options, futures, swaps e.g. Black-Scholes

21. Jeremy Gold Pensions 21 Financial Economics History Three major branches – –Asset pricing –Financial mathematics –Modern corporate finance ignored by most pension professionals including actuaries

22. Jeremy Gold Pensions 22 History Principles –Financial economics –Modern finance –Pension finance Implications Outline

23. Jeremy Gold Pensions 23 Financial Economics Principles –Financial economics analyzes financial systems –All three branches rely on strong assumptions about Transparency Rationality Absence of arbitrage

24. Jeremy Gold Pensions 24 Financial Economics Principles Transparency –Decision makers have inexpensive access to all pertinent information –They can see through institutional structures to the underlying values

25. Jeremy Gold Pensions 25 Financial Economics Principles Rationality –People behave rationally in their own interests –Transparency and rationality imply efficiency – good decisions at low cost

26. Jeremy Gold Pensions 26 Financial Economics Principles Absence of arbitrage –No free lunches

27. Jeremy Gold Pensions 27 Financial Economics Principles We also study the limitations of rationality, transparency, arbitrage

28. Jeremy Gold Pensions 28 History Principles –Financial economics –Modern finance –Pension finance Implications Outline

29. Jeremy Gold Pensions 29 Modern Finance Principles 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

30. Jeremy Gold Pensions 30 Modern Finance Pass-Throughs Humans Institutions Contracts & Cash Flows

31. Jeremy Gold Pensions 31 Modern Finance Pass-Throughs Humans Institutions Contracts & Cash Flows

32. Jeremy Gold Pensions 32 Modern Finance Pass-Throughs Humans Institutions Contracts & Cash Flows

33. Jeremy Gold Pensions 33 Modern Finance Pass-Throughs Humans Institutions Contracts & Cash Flows

34. Jeremy Gold Pensions 34 Modern Finance Pass-Throughs Shareholders own the corporate assets and owe the liabilities Taxpayers own the locality’s assets and owe the liabilities

35. Jeremy Gold Pensions 35 History Principles –Financial economics –Modern finance –Pension finance Implications Outline

36. Jeremy Gold Pensions 36 Pension Finance Modern Finance Applied to Pension Plans T otal employee compensation includes $ today and a contract for $ tomorrow +

37. Jeremy Gold Pensions 37 Pension Finance Ideally the taxpayers pay for both forms of compensation today – at the same time that the employees are serving the taxpayers +

38. Jeremy Gold Pensions 38 Pension Finance The contract is really an annuity and it could be bought today from an insurance company

39. Jeremy Gold Pensions 39 Pension Finance Taxpayers would bear little risk and would be indifferent between paying current $ and promising future pensions

40. Jeremy Gold Pensions 40 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

41. Jeremy Gold Pensions 41 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

42. Jeremy Gold Pensions 42 Pension Finance But the insurer would not recognize the profit immediately Profits would emerge if and when the risks were gone

43. Jeremy Gold Pensions 43 Pension Finance Remember the $1000 bicycle? How much does a $100,000 annuity cost? $1000 $100,000

44. Jeremy Gold Pensions 44 Pension Finance Instead of buying the annuity, the taxpayers could run their own insurance company

45. Jeremy Gold Pensions 45 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

46. Jeremy Gold Pensions 46 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

47. Jeremy Gold Pensions 47 Pension Finance Financial economists would say: –today’s taxpayers were buying annuities –tomorrow’s taxpayers were selling annuities

48. Jeremy Gold Pensions 48 Pension Finance Financial economists would say: –The rewards for taking the risks belong to the future taxpayers

49. Jeremy Gold Pensions 49 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

50. Jeremy Gold Pensions 50 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?

51. Jeremy Gold Pensions 51 Pension Finance Until that moment –Taxpayers were running an insurance business with as little risk as possible –Now they are upping their bets

52. Jeremy Gold Pensions 52 Pension Finance Compared to the insurance company –They are selling bonds and –Buying stocks

53. Jeremy Gold Pensions 53 Pension Finance Financial economists say that selling bonds is the same as borrowing –More money today –Less money tomorrow

54. Jeremy Gold Pensions 54 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

55. Jeremy Gold Pensions 55 Pension Finance Who should get the rewards?

56. Jeremy Gold Pensions 56 Pension Finance When? –After the risks have been taken

57. Jeremy Gold Pensions 57 History Principles –Financial economics –Modern finance –Pension finance Implications Outline

58. Jeremy Gold Pensions 58 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

59. Jeremy Gold Pensions 59 Implications Future taxpayers should complain –They take the risk –Today’s taxpayers take the rewards For crying out loud!

60. Jeremy Gold Pensions 60 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

61. Jeremy Gold Pensions 61 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

62. Jeremy Gold Pensions 62 Implications Who should hate me first? –Today’s elected officials because You will have to give the bad news to your taxpayers

63. Jeremy Gold Pensions 63 Implications Who should hate me first? –Employees because Once taxpayers and elected officials realize how much those annuities really cost They will have to promise smaller benefits

64. Jeremy Gold Pensions 64 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

65. Jeremy Gold Pensions 65 Implications For crying out loud!

66. Jeremy Gold Pensions 66 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 jeremy.gold.wp00@wharton.upenn.edu.

67. 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