The Edmond Sun


June 22, 2012

THE ASTUTE INVESTOR: Fed adding to the financial problems of cities, states

EDMOND — To paraphrase Newton’s third law of motion, for every action there is an equal and opposite reaction. Newton was talking about physical laws, but I like to think that in the world of finance and economics there are similar laws. Some might call them unintended consequences. This past week, as the Federal Reserve contemplated an extension of Operation Twist or some other form of expansive monetary policy, their actions have been causing unintended consequences for cities and states across the nation.

For those not as familiar, an extension of “Operation Twist,” in which the central bank sells bonds with maturities of three years or less and buys securities with maturities of six years and longer, is seen as a less extreme step than outright purchases of new securities. However, in leaving the door open for further action, in the Fed’s post-meeting statement, the Fed said it is “prepared to take further action,” a stronger sign that there may be a third round of quantitative easing, or QE3 coming.

The Fed has broad mandates to maintain stable prices (low or no inflation), moderate interest rates and full employment. Along with these goals, the Fed was given broad powers to affect money in the U.S. Unfortunately, the goals and the tools to do so don’t exactly match.

How does monetary policy lead to jobs? Only by the third or fourth derivative. This means the Fed lowers interest rates or expands money supply, hopes that these actions lead to increased borrowing and therefore spending, and hopes that the spending leads to business expansion, and that leads to jobs. Yeah right! As we have seen with QE1, QE2, Operation Twist and other various programs, reality is often much different than theory. However, in this reality, such programs do create outcomes, even ones you don’t necessarily want.

As the Fed has continued to push on the string of economic activity, it has continually worked toward a lower interest rate environment. This has pushed 30-year mortgages down to 3.53 percent, lowered the cost of borrowing for the U.S. government and corporations, and even made buying a car cheaper.

And then there is the other side of the coin. Not considering individual investors for the moment, large investors, like pension plans, have seen their fixed income returns fall like a rock. This means that these funds have to work hard to make up what has been lost to lower interest rates, which usually involves seeking out higher return alternative investments. That also means higher risk. In the meantime, public pension funds have two all-important numbers they must keep in mind — their assumed rate of return and their discount rate.

The assumed rate of return for a pension is exactly that, the rate the fund expects to earn over the long-term, smoothing out annual gyrations. The discount rate is the interest rate used to determine the present value of estimated fund balances. The higher the expected rate of return, and the higher the discount rate, the less a pension fund has to put away today in order to meet its future obligations. Of course, if interest rates are going lower, then things get dicey. If interest rates stay low, so that funds earn less than they projected and they also have to determine present value with a lower discount rate, then the current funding status of pension funds fall off a cliff. Welcome to the cliff.

We are in year five of the financial crisis, where liquidity has been uneven and only financial engineering from central banks has boosted markets. Financial repression — the artificial suppression of interest rates — is the order of the day and will be with us for at least two more years.

The outcome? According to a study just released from the Pew Center, using 2010 fiscal year data, state pension and health-care funding has imploded, with the underfunded number ballooning from $1 trillion in 2009 to $1.4 trillion in 2011. Only Wisconsin has a fully funded pension fund. Oklahoma is 56 percent funded, although that number has improved somewhat with steps taken during the past two years. No state has fully funded health care. Unfortunately, some states are making matters even worse. In 2010, only 19 of the 50 states made their full pension contribution.

The good news for us locally is that the City of Edmond always has been fiscally responsible and city pensions are fully funded. At the state level, because of the leadership of State Rep. Randy McDaniel on pension reform, we are heading in the right direction.

The truth is these funding numbers are all fantasy numbers anyway. The interest rate environment is low, and will be for years. States are reporting paltry earnings on their fixed income investments and on their overall portfolios. So what do many states do? They continue to assume a 7.75-8.00 percent rate of return, of course. If states actually dropped this number to a more realistic 4.5–5 percent rate of return, then the funding gap would grow by another 40 percent, leading to a $1.96 trillion dollar gap. Ouch!

None of this is exactly news. The reason for pointing out where we are is to bring up the question of, “What’s next?” If states and cities do not have the funding for their pensions and health care, which I have been ranting and raving about for many years, then what is the outcome? On the provider side, it shows up as higher taxes, less service, more layoffs of employees, less funding for universities, etc. On the recipient side, it will require higher contributions and lower benefits.

All of this is leading to a situation where reality is finally acknowledged and these generous plans are recognized as unaffordable. Then the pain of what that reality means sets it. It’s all called austerity, and it soon will be coming to cities and states that failed to act properly. Another reason you can be glad if you live in Oklahoma. Thanks for reading.

NICK MASSEY is a financial adviser and president of Householder Group Financial Advisors in Edmond. Massey can be reached at Securities offered through Securities Service Network Inc., member FINRA/SIPC.

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