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What We’re Reading This Week

Government Accounting

I came across a great article at the Financial Times. The author reviews the government’s accounting standards and concludes that mismanagement of our state and local governments is foundationally rooted in the guidance from the Governmental Accounting Standards Board (GASB).

One area of concern is asset values, like property used for airports, schools, and office buildings. GASB Statement 6 states that governments shouldn’t value their assets based on market prices. The GASB states that asset value should be calculated based on the amount of money spent on acquisition, regardless of how long ago the asset was acquired. Additionally, the guidance further articulates that the asset’s value is only relevant to the extent that it relates to the properties’ current function.

“Financial reporting should help users assess whether current-year revenues are sufficient to pay for the services provided that year and whether future taxpayers will be required to assume burdens for services previously provided… In the assessment of whether current-year revenues cover the cost of the government’s services, the most relevant cost associated with these assets is the cost that has been incurred by the government — the cost based on the initial amount. By contrast, costs that have not been incurred for assets used to provide services — those based on remeasured amounts — do not reflect a burden on current resource providers.”

In the private sector, a company’s investors would demand property be sold or repurposed if its current market value far exceeded the production value. Sure, governments aren’t the private sector, that’s what makes them governments. So why do they do it? Maybe there is a secret government benefit?

“Application of initial amounts to assets that are used directly in providing services is supported by cost-benefit and timeliness considerations. The cost of reporting assets used directly in providing services at a remeasured amount frequently is greater than the cost of reporting them at their initial amounts and may negatively affect timeliness of financial reporting.”

If I’m reading that correctly, they are doing it because it’s cheaper and easier.

Also addressed in the article are government pensions. The municipal bond market is currently worth around $3.8 trillion. Joshua Rauh of Stanford values government pensions at roughly $7.4 trillion. When you look at underpaying current employees and promises of a large pension in the future, these benefits are decidedly the government’s favorite way of borrowing money.

This is an oversimplification, but at its core the economic cost of a pension is the value of the promise to pay the benefit. Just like that municipal bond market, a pension is a promise to pay over a fixed period of time. You need to know how much will be paid and how long it will be paid (actuaries calculate that) and then you can use a risk-free rate with a similar duration to discount the value of the pension. Essentially, you would use long-term treasury yields.

According to Rauh, the discount rate used by pension is 7.4%. This number is roughly based on the expected rate of return and effectively reduces the value by 1/3. According to the Financial Times, “The spread between the 30-year UST yield (currently around 2.8%) and this made-up discount rate implies a cumulative implied probability of default of about 75% over a three-decade span — with no recovery in the event of default.” That’s um, not great.

According to the GASB:

“The actuarial present value of benefit payments projected to be made in the period should be determined using the long-term expected rate of return on those investments. The long-term expected rate of return should be based on the nature and mix of current and expected pension plan investments over a period representative of the expected length of time between (a) the point at which a plan member begins to provide service to the employer and (b) the point at which all benefits to the plan member have been paid.”

I wonder how California feels about that?

Index Funds

This year we reached an important milestone: there are more stock indexes than there are actual stocks. This is, indeed, the year of the ETF. The evolution makes sense. Previously, investing was done by giving your money to a mutual fund with an active manager, sometimes a rock star manager, like Bill Gross. These larger-than-life fund managers would do a ton of research and then invest your money in stocks they liked. Lately, people don’t trust these guys as much as they used to and a lot of research tells us that you can get similar (or better) returns by just investing in the cheap index these funds were competing against. At the end of the day though, these guys still need jobs. So what happens? We get weird indexes!

Apart from building exotic options, the ETF business is one of cost reduction. Over the past year, roughly $500 billion has flowed into the ETF market. Increasingly, the lowest cost ETFs are winning business, creating a race to $0. For the major indexes, the S&Ps of the world, this is where you live. After that, you have to assume that fund companies and index makers will have to get creative. They also need to find work for these fund managers. First we had “smart-beta.” After that we explored indexes based on companies with female CEOs, and the Quincy Jones Streaming Music, Media, and Entertainment ETF! Also, who could forget Dani Burger’s Cat Index?

Of course, once everything becomes an index, nothing is an index. Or put differently, when everyone is a passive investor, active management will become more relevant. In the meantime, maybe that Cat index will take off and we can have some fun on the way.

Adding Value

Financial advisors and the compensation they receive will always be near and dear to my heart. Mostly, because it’s what I do for a living. For the past 2-3 years I’ve come across articles like this one which asks the question, “Are we paying too much for advice?”

Wealthfront, Betterment, and Vanguard are the industry leaders in moving towards providing advice steeply below market rates. As these services gain traction in the market, traditional advisors will feel the compression. According to Paul Auslander, the director of financial planning at ProVice Management Group, “It’s always been questionable whether or not advisers were earning (their) money at 1% and up. The spread’s got to narrow.” The landscape seems similar to the investment product market we just explored. ETFs are getting cheaper and price is a major factor. However, there is little room for ambiguity.

An S&P ETF has a fairly straightforward plan: figure out what stocks make up the S&P, weigh them for market capitalization, and then buy them. Finally, you stop once you have bought all of them. If company A does it for .10% and company B does it for .15%, you should probably buy company A’s ETF.

Financial advice is a little harder to quantify and no one seems to be examining it. On one side, low cost alternatives talk about how they are providing advice services for less and on the other side, overpaid advisors complain about price compression. What you don’t see is discussion about knowledge and service gaps in phone or web-based financial advice. Nor do you see financial advisors admitting that the advice they give barely qualifies as advice. When financial counseling is reduced to picking investments and providing rudimentary retirement projections, I would agree: it can be done for very little money.

Real planning, however, requires more knowledge and attention than discount advisors are capable of. When I review the Vanguard Personal Advisor Services webpage, they list three ways that they add value: investment coaching, tax planning, and buying low cost vanguard funds. Their tax strategies are based on asset diversification and withdrawal tactics. All three of these approaches are investment-related, not financial planning-focused. Firms that invest heavily in real financial planning, like Gainplan, will never feel that market compression. Ultimately, both traditional financial advisors and online advisors are wrong. The traditional advisor is wrong because they are charging too much for advice that ranges from nonexistent to poor. Discount firms are wrong because they are operating under the assumption that the advice is ok, it’s just too expensive. When I work with new clients, I see a retail market that is looking for real advice from experienced, certified professionals. There are not enough firms providing this service.




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Categories: Gainplan Facts, Industry Ideas, News, The Market

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