No More Dizzying Earnings Adjustments [Wall Street Journal]

Whether Microsoft’s $26.2 billion purchase of LinkedIn makes sense might depend on where you look. Glancing at LinkedIn’s press release for the full year 2015, you will see a prominent projection for “adjusted” earnings this year of $950 million.

Yet if you closely read the press release and its appendix, you can figure out that the company’s projected 2016 earnings under GAAP, the generally accepted accounting principles required in securities filings, are minus $240 million.

What accounts for that enormous difference? Like many companies, LinkedIn reports one set of figures to the Securities and Exchange Commission but touts adjusted figures elsewhere. LinkedIn’s adjusted projection excludes large expenses: $630 million for stock awards to executives and $560 million for depreciation and amortization.

Read the rest at wsj.com…

Independence is a Desirable Quality in Chairmen [Financial Times]

In the 2015 proxy season, shareholders submitted more than 60 proposals asking US public companies to appoint an independent director as a board chairman, as opposed to one person serving as both chief executive and chairman.

In 2012, 45 per cent of the S&P 500 companies split the chief executive and board chairman roles, almost doubling from 23 per cent a decade ago. However, of the 45 per cent, roughly half of the separate board chairs were held by former chief executives.

By contrast, most public companies in Europe have a truly independent director as board chairman. Some commentators have suggested that the US adopt the European model.

While US companies typically oppose this suggestion, they should ask three practical questions:

Would an independent chairman improve the financial performance of the company substantially? Could the internal governance functions of a company be satisfied by other measures? And would an independent board chairman significantly reduce the time spent by a chief executive engaging with shareholders?

After reviewing empirical studies, David Larcker, professor of accounting at Stanford University, concluded that there was no systematic evidence for or against an independent chairman. Similarly, a further study found there is “no statistical relationship between independence and firm performance”.

However, a 2012 study by GMI Ratings, the research provider, showed that, over the past five years, large US companies with a separate board chairman had higher stock increases than companies with a combined chief executive and chairman. Yet another study found that separating the role of chairman from that of chief executive improved financial performance only when the company had been doing poorly.

Read the rest at ft.com…

The Role of Institutional Investors in Curbing Short-Termism [Financial Analysts Journal]

Across the world, a clamor is rising against corporate short-termism—the undue attention to quarterly earnings at the expense of long-term sustainable growth. In one survey of chief financial officers, the majority of respondents reported that they would forgo current spending on profitable long-term proj- ects to avoid missing earnings estimates for the upcoming quarter.

Critics of short-termism have singled out a set of culprits—activist hedge funds that acquire 1% or 2% of a company’s stock and then push hard for measures designed to boost the stock price quickly but unsustainably.2 The typical activist program involves raising dividends, increasing stock buy- backs, or spinning off corporate divisions—usually accompanied by a request for board seats.

Read the rest at cfapubs.org…

Relief for Cities’ Budget-Busting Health-Care Costs [Wall Street Journal]

Co-authored with Joshua Rauh

The budgets of many cities and states will soon be disrupted by new accounting rules for retiree health plans. Local governments pay most of the health-insurance premiums for their retired employees—for example, from age 50 until Medicare at age 65, and sometimes for life. Nationwide, the total unfunded obligations of these plans are close to $1 trillion, according to a comprehensive recent study in the Journal of Health Economics.

The accounting rules, adopted in June by the Government Accounting Standards Board (GASB), require local governments for the first time to report their obligations for retiree health care as liabilities on their balance sheets. Local governments must also use a reasonable and uniform methodology to calculate the present value of these liabilities. These are both steps forward, enhancing transparency and accountability.

The new rules further provide an incentive for local governments to establish a dedicated trust with assets invested today to help pay health-care benefits in the future. But here the GASB takes one step backward, by allowing local governments to make overly optimistic assumptions, including excessive returns for the trust.

Read the rest at wsj.com…

Let’s Cut Taxes By Reducing Tax Bias [Real Clear Markets]

Tax experts from around the world gathered two weeks ago in Washington DC to push forward a Euro-led project for the prevention of BEPS — base erosion and profit shifting. This project is aimed at getting multinational companies to locate facilities and jobs in real countries, instead of post office boxes in tax havens.

The corporate tax rates in Europe are already 10% to 15% lower than the 35% rate in the U.S. If Europe moves forward with BEPS, that will put more pressure on US large companies to move people and plants abroad — unless Congress substantially reduces the U.S. corporate tax rate.

While almost everyone wants to reduce the U.S. corporate tax from 35% to 25%, almost no industry is willing to give up its current tax preferences to achieve this rate reduction on a revenue neutral basis. This means that the national debt would not rise because revenues lost by rate reduction would be offset by revenues gained by restricting existing tax preferences.

Therefore, Congress should finance a substantial lowering of the U.S. corporate tax rate largely by reducing the tremendous bias in the current tax code for debt and against equity. Most importantly, companies may deduct interest paid on all their debt, but may not deduct any dividends paid on their shares. As a result, the effective tax rate on corporate debt is negative 6.4%, as compared to positive 35% for corporate equity, according to the Congressional Budget Office.

Read the rest at realclearmarkets.com…

Has the Death Knell of Active Management Been Rung Too Soon? [Financial Times]

Coauthored with Theresa Hamacher

The death knell of active portfolio management has been rung. But with recent studies suggesting that the costs of passive management are rising, has the bell tolled too soon?

Last year, Charles Ellis seemed to predict the imminent demise of active management when he wrote that “the costs of active investment are so high and the incremental returns so low that, for clients, the money game is no longer a game worth playing”. Mr Ellis, a longtime commentator on asset management trends, suggested that investors would be better served if investment professionals shifted their focus toward financial planning and away from stock picking.

Mr Ellis’s comments only reflected what was happening in the investment world. Investors have been steadily shifting assets from actively managed funds into passive. At the end of 2013, index funds accounted for one dollar of every five invested in U.S. mutual funds overall and, stunningly, more than one-third of the assets in US equity funds.

While the interest in index funds is understandable, the disdain for active management is ironic. Active management is what makes index funds attractive in the first place.

How is that? Proponents of passive investing argue that index funds are the only logical alternative when markets are efficient, meaning that asset prices accurately reflect all information. Active managers have a tough time making money in efficient markets because asset mispricings are rare. In efficient markets, index funds generate the same returns while costing less.

Read more at ft.com

Unfunded Retiree Healthcare: The Elephant in the Room

Unfunded Retiree Healthcare: The Elephant in the Room

The following outline is accompanied by a set of slides that were recently presented at the the Stanford Institute for Economic Policy Research in November 2014
Download the Slides
Watch the presentation on youtube.com

  1. When Detroit declared bankruptcy, the press highlighted its unfunded pension obligations. But actually its unfunded retiree healthcare liabilities were almost twice as large. This is why we say that retiree healthcare is the elephant in the room –sitting quietly with little notice in the halls of cities and states
  2. This set of slides will turn the search light on retiree health care benefits in 4 steps:
    1. Define these benefits and how they are reported by states/cities,
    2. Outline the huge amounts of unfunded liabilities for these benefits,
    3. Compare the rules on public pension to those on public retiree healthcare, and
    4. Evaluate various proposals to curb the growth of unfunded healthcare liabilities.
  3. Retiree healthcare benefits mainly take the form of government subsidies of insurance premiums to public employees who retire before going on Medicare at age 65. Sometimes these premium subsidies extend to premiums for Part B of Medicare and even Medigap. These subsidies range from 50% to 80% of the retiree’s premiums on a high-end healthcare policy.
  4. Retiree healthcare benefits constitute the bulk of OPEBs – other post employment benefits. Before 2006, there was virtually no disclosure about OPEBs so they could be increased without political accountability. Since 2006, GASB has required states and cities to report on their OPEBs in the footnotes to their financial statements. But GASB has never required any advance funding of OPEBs, as is required for public pension plans.
  5. Recently, GASB has announced proposals to standardize the calculation of OPEBs – most importantly, by mandating the use of a discount rate based on AA rated bonds. Under these proposals, OPEBs would be included as liabilities on city and state balance sheets. These proposals, if adopted, could affect bond ratings and focus political debate on this subject.
  6. Turning to the scope of the problem, we can see a big discrepancy between states. States like NY and NJ each have over $60 billion in unfunded liabilities (and high OPEB per capita). States like South Dakota and Idaho have low unfunded liabilities (and low OPEB per capita). This depends on the number of public employees covered by OPEBs and the extent of their benefits. (The median state in this S&P survey of unfunded OPEB liabilities was $1,219 per capita).
  7. The problem of unfunded OPEB liabilities is growing in many states due to chronic underfunding. Here we see in the left bar the percentage of state tax revenues actually used to fund OPEBs, versus the higher percentage that should have been contributed based on 6% returns and 30 years of level payments. States are justifying their lower contributions by back-loaded amortization periods and assumptions of higher returns. According to JP Morgan, most states annually contributed 30% to 60% of what was needed to fund its OPEBs.
  8. Similarly, on the city level, we see a great disparity in levels of OPEB funding across the country. The unfunded OPEB liabilities of New York City were twice the total of the 30 largest cities. And New York City also had the highest unfunded OPEB liability per household, followed by Boston. The figures of New York City include its obligations to teachers for retiree healthcare. By contrast, Denver, Minneapolis and Tampa had very low unfunded OPEBs by dollar amount and household.
  9. The situation in California is complex. The unfunded OPEBs from State government is almost the same amount as New York State, though California has a lower unfunded OPEB liability per capital. But other governmental units in California have promised healthcare benefits to their retirees. These include counties, cities, school districts, the UC system and the trial courts. Thus, the total OPEB liabilities for California were over $157 billion, of which less than 5% was funded.
  10. The level of OPEB funding is much lower than the level of pension funding , because there never has been a funding requirement for OPEBs.   As a result, OPEBs must generally be funded out of current tax revenues. On the other hand, pension obligations to employees are often protected by statute or state constitution. Since these protections do not generally apply to OPEBs, they are easier to change from a legal viewpoint, though these changes are still often subject to collective bargaining.
  11. Because OPEBs are generally funded out of current tax revenues, it is useful to compare the growth trends in OPEBs and property taxes. This comparison is made in the chart on page 11. The increase in retiree healthcare costs ( HC ) is absorbing a large portion of the growth in property taxes in 3 of the cities, and actually exceeds the growth in property taxes in Springfield.
  12. Let’s look at Newton, a Boston suburb with 170,000 people.   Newton is spending $21 million per year on retiree healthcare benefits — which equals $747 per household or 7.5% of the average property tax bill. To increase property taxes by $8.4 million, Newton had to pass an override of proposition 2.5. But most of that increase — $8.1 million — is going to pay retiree healthcare benefits as they rise. If that $8.1 million instead had gone into adding teachers, Newton could have hired 79 more teachers.
  13. So what can be done to constrain the growth of OPEBs? It is very difficult to reduce healthcare benefits going to those already retired. However, some jurisdictions have directly addressed healthcare costs in the future: by increasing future deductibles and copayments, decreasing cost of living adjustments and reducing the scope of subsidized healthcare services — e.g., retirees pay full premiums of dental and eye care.
  14. In California, the courts have generally been receptive to modest limits in OPEB benefits. The courts have generally taken the position that counties did not promise PERMANENT healthcare benefits as a specific level, and they are not guaranteed by statute or the constitution. But the court rejected the changes proposed by Los Angeles City as an impairment of a vested right — citing precedents from pension law.
  15. Another approach is to revise the eligibility standards for retirees to qualify for OPEBs. A worker can qualify for OPEBs in Mass, for example, after only 10 years of PART TIME work. Many workers can receive OPEBs even if they retire and go to work for a company with healthcare benefits. When workers reach age 65 and go on Medicare, they could be asked to pay their own Part B premiums.
  16. The majority of states have cost of living adjustments built into their OPEB plans. Yet 17 states have recently reduced COLAs for retiree healthcare benefits. While most of these COLAs reductions were legally challenged, the courts have generally upheld these reductions on the theory that the COLA portion is not a contractual right.
  17. Most healthcare plans utilized by retirees with OPEBs are relatively high cost and high quality. Very few of these plans are provided through a state connector offering a menu of healthcare plans. However, an individual can receive federal premium subsidies under Obamacare only by purchasing a policy on a state connector. Thus, if retired public employees were required to obtain their policies through the state connectors, the federal premium subsidies could be used to offset local premium contributions.
  18. Here is an illustration of the costs and premium subsidies for a gold level plan from the Mass connector. For a family of four with an annual income of $50,000 per year, the government premium subsidy is $945 per month out of a total policy cost of $1,319 per month. Thus, the city or state could be pay NO premium subsidy and the retiree would receive a high quality plan for only $374 per month.
  19. Conclusions — While unfunded OPEBs have been rising faster than unfunded pensions, the OPEB situation will become highlighted by the new disclosure and accounting rules.These new rules should stimulate an open and honest debate on the various proposals to limit the growth of unfunded OPEBs, which are legally easier to change than the provisions of a public pension plan.

Secret Juice: Interview of Bob Pozen [CFA Institute]

pozen1

Are obsolete ideas about productivity holding back investment professionals? The modern investment industry is a knowledge-based business operating with an industrial-era mentality about time management, according to Harvard economist (and Future of Finance adviser) Robert Pozen. In the November/December issue of CFA Institute Magazine, he explains why professional investors who want to excel “must totally change their mindset” about productivity.

Read the complete article online here.