Reviewing the economic history of the past 35 years, one finds that two groups of people are getting richer: the executives who sit on each other’s boards and vote each other a rising share of private sector income, and the retired, particularly retired public employees and those approaching retirement, who control state and local government. Everyone else is getting poorer, a trend that has been covered up first by having a higher share of family members in the workforce, then by taking away their future income when they themselves reach old age, which doesn’t affect their current spending, and then by debt. There is, in other words, the executive class, the political and politically organized class, and the serfs, with the latter including members of generations born after 1955 or so in the former middle class. The point of intersection between the two advantaged groups is the projected rate of return for public employee pension funds, and the Wall Street firms that manage them.
From 1982 to 2000, top executives justified their exploding pay by the “shareholder value” they were creating. But that value was illusory, a combination of a stock market bubble, which drove up the price of company stock relative to the money those companies earned, and fraudulent disclosure of earnings. There was a second bubble, mostly in housing, and mostly limited to the financial and real estate sectors, ending in 2007. That was illusory too.
Yet somehow after the first bubble popped and even after the second bubble popped, wiping out the excuse of the executive pay explosion and showing that excuse had been a fraud, executive pay did not return to its former level. The pay of the top one percent continues to rise compared with just about everyone else in the private sector, without any rationale at all.
Some will speak about the “free market” in executive pay. But that market is hardly free, given that one’s pay is determined by one’s cronies who know that one executive’s pay will become the benchmark for their own. When is the last time a Board of Directors dumped an executive team to bring in cheaper employees so it could pay more dividends? Executives outsource to cheaper rank and file employees so they can increase executive pay all the time.
The promise of outsized stock market returns was not only used to justify soaring corporate executive compensation, but also to justify an assumption of historically unrealistic future rates of return in public employee pension funds – from the peak of the stock market in 2000. And those excess stock market returns were used to justify all kinds of pension enhancements for public employees in all kinds of political deals, and their description as free. In most states, those deals stopped (leaving a huge hole) after the stock market bubble burst in 2000. In New York State, they continue to this day. As in the case of executive pay, the rationale has long been exposed, but the grabbing continues – with devastating consequences.
It is absolutely clear that the expected rate of stock market returns should be a rule not a number. The U.S. economy is at a point where the only certainty is the massive debts run up over the past 30 years – public, corporate, personal. Those debts might lead to an ongoing deflationary spiral, and another Great Depression. Or they might leave to a generation-plus of stagnation, with lower interest rates and stock market returns, as in Japan. Or they might lead to an inflationary spiral, as the foreigners flee the dollar and the U.S. government continues to print money to stave off an economic collapse. I don’t know what will happen. No one does.
There are three components of stock market returns.
The first is the dividend yield, which is the dividend paid for a share of stock divided by the price of that stock. That is the actual income you get for owning part of a company. Historically, the average dividend yield for the S&P 500 is about 4.3%. During the peak of the stock market bubble in 2000, that dividend yield had fallen to around 1.0%, because the prices has risen so high relative to the money companies were paying out to shareholders. That meant that if you bought stock in 2000, the return you could have expected to get from dividends into the future on that stock was just 1.0%. Today, with stock prices still high by historical measures, you can only expect 1.8%. And that, I believe, is the dividend yield that should be assumed for the pension rate of return – the current yield, whatever it is on average in the previous quarter.
What do corporate executives and Wall Streeters say about the decline of dividends for their investors? The story around 2000 was that instead of paying dividends, which were taxed at a high rate as ordinary income, companies were better off using their earnings to buy back stock. That would make the remaining stock more valuable, increasing its price, and allow shareholders to sell their holdings for capital gains, which were taxed at a lower rate.
Since 2000, every part of that argument has been exposed. First, if from 1990 to 2010 the average company had used earnings equal to 1.8% of the stock price for dividends and 2.5% for stock buybacks, instead of 4.3% for dividends, then 2.5% of the stock would have been taken off the market every year. By 2010, there would be 40 percent fewer shares traded than there had been in 1990. While I don’t have the data, I strongly believe that is not the case – I do know of one billionaire whose company could probably confirm this one way or the other.
Second, stock prices haven’t provided capital gains, because they haven’t been any. The S&P 500 was about the same in March 1999 as it is right now, nearly 12 years later.
Third, in the early 2000s the tax law was changed to cut the tax rate on dividends to 15 percent, the same as the tax rate for capital gains. Advocates for business, blaming the government and taxes for the loss of dividends, claimed dividends would follow. They haven’t.
What I believe has happened is that much of the money that once went to dividends now goes to increased executive pay, and since that pay has often been in the form of stock options and grants, all or most of the reduction in stock due to stock buybacks has been offset by the new stock executives grant each other, leaving the shares in circulation unchanged.
It was once argued, early in the executive pay explosion, that since executive pay was such a small share of total costs, it made sense for Boards of Directors to pay whatever it took to get the best executives. Well, the pay going to the top one percent is no longer a small share of total costs – and it never was a small share compared with dividends paid. I believe the increase in pay has taken the place of dividends paid.
The second component of stock market returns, the one that has been missing for 12 years, is capital gains, but it too has two subcomponents.
The first is inflation. If the price of a share of stock increases at the inflation rate, the stockholder isn’t becoming wealthier. Because what they could buy with the proceeds after selling that share of stock is not, in the aggregate, changing over time. Relatively high inflation, therefore, makes stock returns appear higher than they are, but inflation is much lower than it once was. In fact, based on the spread between 10-year U.S. Treasury bonds and 10-year Treasury Inflation Protected Securities, the consensus view is that inflation over the next 10 years will be about 2.3%. That is, a new 10-year Treasury bond bought last week would provide an interest rate of about 3.3%, whereas a 10-year TIPS would provide 1.0% over inflation: if inflation turns out to be 2.3%, you’d end up with the same return on both.
The second component of capital gains is the increase in stock prices in excess of inflation, not counting reinvested dividends. It is less than you think – I’ve heard it variously estimated between 0.5% and 1.0% historically. There it is. There is your real capital gain. Not realistic? Consider that it is higher than has been actually achieved for the past 12 years, and perhaps much longer. To calculate it, I would use the actual increase in the S&P 500 absent reinvested dividends (and adjusted for stocks kicked out of the index for not doing well) from the low point of the Great Deppression to the low point of the Great Recession (so far) on March 9, 2009.
So the right rule for public employee pension funds to use for stocks is the historical real (inflation adjusted) capital gain, the expected rate of inflation over 10 years based on the gap between 10 year Treasuries and 10 year TIPS, and the current dividend yield. Based on the current data, the expected rate of return should be 1.8% for dividends plus 2.3% for inflation plus the 0.5%, for a grand total of 4.6%. That is 2.3% more than expected inflation.
If the intention is to actually pay those public employee pensions, that is the return that should be expected for stocks, and enough money should be set aside to cover the pensions with that rate of return. Instead, Comptroller DiNapoli cut the expected rate of return for New York’s pension funds from 8.0% to 7.75%, based on nothing. The New York City rate of return is under study.
What would have happened if my proposed rule had been in effect for the past decade plus?
In 2000, based on the late 1990s stock market bubble, politicians and unions cut a deal to assume that future returns would be 8.0% from the top of the bubble, not 7.0% from a more reasonable stock price as had been assumed previously. In March 2000 the S&P 500 peaked at 1523 – the NASDAQ was over 5,000 compared with 2,750 today. We don’t have a TIPS/Treasuries spread for that time, but we do have an actual inflation rate for the 2000 at 3.8%. The dividend yield, as mentioned, had fallen to 1.0%. Add in a historical inflation adjusted capital gain of 0.5%, and the expected return would have been 5.3%, or just 1.5% more than inflation. The meaning of the latter figure would have been this: since stock prices were inflated, lower returns would be expected going forward.
The recent low point for the S&P 500 was hit in March 2009 at just 677. At the time, the Treasury/TIPs spread showed an expected inflation rate of 2.0% over a decade. Because stock prices had fallen, the dividend yield had increased to 3.6%. Add in 0.5% for real capital gains, and the expected return would have been 6.1%. Or 4.1% more than expected inflation in March 2009, compared with 1.5% more than inflation in March 2000 and 2.3% more than inflation today. The message of the 2009 figure – since stock prices were lower (though not low compared with the 4.3% historical average) relative to dividends then, better returns could be expected going forward.
None of these figures comes close to supporting an expected return of 8.0%, or 7.5%, or even 7.0% for stocks in public employee pension funds. Those returns were based on a) the late 1990s stock market bubble and b) an expectation of higher inflation. If people were honest, all those retroactive pension enhancements for public employees would not have passed. And the nonsense that “Wall Street incompetence” is responsible for the current public employee pension fund disaster would not be asserted by public employee union leaders today. In fact, Wall Street greed and incompetence is responsible for stocks having been that overpriced to begin with. The idea that they could have soared in price from there is a lie.
Stocks remain overpriced. If inflation stays low, the nominal rate of return on a stock portfolio owned today would be less than 5.0%.
What about private equity? Private equity funds promise a higher return based on an expectation of another stock market bubble, which would provide the ability to sell companies back to stockholders, which is to say back to the pension funds, at inflated prices. If the pension funds are not buying at inflated prices, there is no bubble and no excess returns for private equity (other than the excess pay of private equity managers).
Most hedge funds don’t hedge, which is to say accept lower returns in exchange for more stability. They just leverage up with borrowed money to inflate returns in good times (paying themselves massively) and go bust in bad times, taking back 100 percent of what they had earned. For pension funds, which have to hold investments for years to pay for benefits far in the future, the only difference in returns is the interest paid on the debts and the excess pay for the hedge fund managers.
What about bonds? Since fixed income investments have more stable values, and thus are expected to be the “certain” assets that can be sold to pay benefits in the short and intermediate run, assumptions should be even more conservative than for stocks. Right now, as mentioned, the yield on a 10-Year Treasury bond is 3.3%. The Dow Jones corporate bond index is 3.8%, and you have to reduce that yield to factor in losses due to bankruptcies. Higher yields are available elsewhere, but with higher likelihood of bankruptcy.
On the other hand, all the pension funds probably have bonds, purchased in the past when interest rates were higher, paying higher interest rates than this. Eventually, however, those bonds will either come due or be called and refinanced – and the proceeds will have to be reinvested at current rates. I don’t see how expected fixed income returns for public employee pension funds can be any different than the current return on existing bonds held by the funds gradually blending into the current rates in the marketplace as existing bonds come due. What might that expected return be today? Perhaps 4.5%? Not 8.0% or 7.5%.
And if the expected return on stocks is 4.6% and the expected return on bonds is 4.5%, why invest in riskier stocks? Only because you expect the Untied States to try to (and succeed in) inflating away its excess debts. A 4.5% fixed return isn’t much when inflation is running 8.0% per year – when you finally get your money back from the bond you can buy less than when you invested in it to begin with. At these low interest rates bonds are overvalued. At these dividend and earnings rates stocks are overvalued, since those earnings depend on the government going deeper and deeper into debt, so business in the aggregate can pay workers less and still sell them things. So with regard to my own savings, I have some of it in stocks, but most of it in cash – because a rate of return of zero looks pretty good compared with the alternatives, until a crash restores real value. Even retirement savings.
So there you have what the expected rate of return for public employee pension funds should be. Or what the rule should be, with the actual rate adjusted every quarter as we find out how things turn out.
But what about executive pay?
The real reason business turned against President Obama is because he raised the issue of undeserved excess pay, not any of his policies. But honest businessman John Bogle and many others have done the same, including many of the most pro-capitalism people out there. I try to avoid getting robbed by handing my savings over to a bunch of cronies who will hand it over to each other by investing in the stock market. But it doesn’t matter, because Mr. Liu and Mr. DiNapoli are handing over my children’s future through the public employee pension funds – promising they will be sacrificed to make up for whatever is taken.
There are four kinds of companies.
First there are those that are well run, stable and strong, and paying dividends at least equal to the yield on a 10-year Treasury bond, which today is 3.3%. I don’t care what those companies pay their highest paid staff.
Second, there are those that are on the way up (or, after a fall, are being turned around). They aren’t paying dividends because they are reinvesting earnings in the company. My view is if the executives are telling shareholders to wait for a payoff, then the top paid employees of the company should also wait, and no one should be paid more than the President of the United States except in stocks and options that would only pay off if and when shareholders eventually get a return at least equal that 10 year Treasury bond. That means (adjusting for inflation since the last time the President’s pay was increased) about $500K plus a house up front. I don’t think real business leaders like Steve Jobs and Warren Buffett were paid more than that up front in cash. The rest of their wealth has come from their firms succeeding over the long run, for both themselves and their investors.
If the current dividend yield is not at least 3.3% of the stock price (or whatever the 10-year Treasury bond yield is at the moment), public employee pension funds and investors and general should demand that executive pay be cut and dividends be increased with the savings. On the assumption that the firm is a third type of company, one being raped by its executives, the way state and local governments are being destroyed by public employee pension funds and the politicians they control. A company where shareholders are waiting for capital gains that will never come.
And if the Board of Directors does not cut executive pay and increase dividends, those stocks should be sold, and the share of the pension funds invested in stocks should fall and the share invested in cash should increase. This would have gotten investors out of the stock market bubble in the run up to 2000.
Is there no circumstance where the dividend yield could be low and yet the executives are doing a great job and deserve more than $500K? Sure there is – if the stock price is too high due to a bubble. If the stock price doubles and dividends stay the same, the dividend rate of return for those buying in at the higher prices would be cut in half. I remember honest Microsoft executive Steve Ballmer, at the height of the tech bubble, saying that although the firm was working hard to succeed and expected to succeed, there was no way it could succeed enough to justify its stock price at the time. If you have a fourth type of company – well run but with an overinflated stock price – the right move is to sell, and buy back in later when the bubble bursts.
But public employee pension funds do not buy shares of ownership in U.S. companies, and demand lower pay for their overpaid top employees and higher dividend yields for investors like themselves. They lie about the future rate of return to give more riches to the pension rich, hand the money over to the overpaid on Wall Street who agree to higher bonuses and stock grants for the bonus rich, and make taxpayers make up any losses due to overpaid executives. That is the point of intersection, and just remember as they point the fingers at each other, for most of us they are on the same side.