The Last Honest Man in Finance and the Expected Rate of Return
You may not have chosen to believe me, when I pointed out that the retroactive pension enhancements for public employees, particularly for NYC teachers, would destroy public services, particularly the NYC schools, because so much more money would have to be spent on the pension plans and not the classroom. But now we have independent confirmation from both an independent actuary and the Center for Retirement Research at Boston College that the NYC Teacher pension plan is one of the handful of most desperately underfunded major pension plans in the country. Two sources with two points of view, neither of which is right wing anti-union anti-worker although that is the shrill excuse the unions are making.
And you may not have chosen to believe me when I showed that as a result of the pillaging of corporations by those who run them, lower interest rates, and lower inflation, the expected future rate of returns on pension assets is much lower than most public employee pension funds assume. But would you believe John C. Bogle, founder of investment giant Vanguard Funds and the last honest man in finance? I certainly have, which is why I haven’t believe the BS Wall Street has been putting out for 15 years.
Bogle’s latest article, taken from his latest book, is in the Financial Times. It is behind a pay wall, but you can register for free to see a limited number of articles.
“During the past century,” according to Bogle, “the US stock market has provided an average annual return of about 9 per cent – 4½ per cent from dividend yields and 4½ per cent from earnings growth.” Sounds good right? Just get 9 percent from stocks and 7 percent from bonds, average them together, and you get your 8 percent assumed rate of return. “But today’s dividend yield is only about 2 per cent, meaning that a critical component of the stock market’s return has been slashed by more than one-half.”
So with 5 percent from earnings growth and 2 percent from dividends, you are down to a 7 percent return on stocks (and based on today’s interest rates, less on bonds). “These returns are conventionally measured in nominal terms, and are almost certain to overstate the painful reality for investors building long-term wealth. Consider the results of that historical nominal return of 9 per cent, compounded over 50 years: a $10,000 initial investment would grow to $743,000 (including reinvested dividends). But after adjustment for 4 per cent inflation during that period, only 5 per cent would remain in real terms.” And that is with a 4.5% dividend yield. With a 2 percent dividend yield, you are down to 3 percent more than inflation.
Now let’s think about this a minute. If you had 4 percent inflation, plus 1 percent for real price appreciation, plus a 2 percent dividend yield, you are up to a 7 percent expected rate of return. Which is one hell of a lot more than we have been getting. The inflation adjustment for pensions used to be zero, but is now half the inflation rate, so it would be 2 percent. That means inflation would help the pension funds recover by increasing nominal returns. Bad for the pensioners, but it might allow public services to survive.
Since inflation is a back door partial default on all debts (including pensions), because you are paying those debts back in money worth less than the money borrowed, the Federal Reserve is desperately trying to create some inflation, to prevent our over-indebted economy from a spiraling collapse. But there are two problems with this.
First, only with those who have the political power to have their income keep up with inflation and force others to pay for it, such as senior citizens receiving Social Security, unionized public employees, and top executives, are likely to do so. The rest will get poorer and poorer as prices rise faster than wages (this has already been happening, over the long run, for some time).
Second, some believe that the overall environment is so deflationary that the Federal Reserve may not succeed. Imagine your wages falling, the cost of living going down somewhat less, but having to pay more in taxes because retired public employees are guaranteed a 1.0% “cost of living increase” even if their cost of living (and the wages of those paying taxes) is going down? Current estimates of future inflation run from 2 percent to 2.5 percent for the next decade. Not 4 percent. So knock another 1.5 to 2 percent off the expected rate of return.
So you can see the dilemma monetary officials have, given the hole American society, public and private, has dug itself into through massive debt. We don’t know what will happen – inflation or deflation. As Gozar the Gozarian said in Ghostbusters: “Choose the Form of the Destroyer!”
Finally, notes Bogle, we haven’t accounted for Wall Street’s cut. “Whatever the future returns of the stock market prove to be, investors should not count on receiving it. Of course, investors as a group must and will earn whatever returns the market delivers. But only before the deduction of the costs they incur. Remember: gross return, minus the costs of investing, equals the net return shared by market participants. Over an investor’s lifetime, that difference is powerful.”
So there are three errors. “Combined, these three errors have an impact that is hardly trivial. Counting on historical stock market returns to repeat themselves is one error; counting in nominal dollars rather than real dollars is another; and counting on capturing the gross returns of the stock market rather than net (after-cost) returns is yet another. These are not just arithmetic errors; they have powerful real-world implications. Individual investors who rely on the historical stock market returns presented by mutual fund marketers will be shocked at the paltry amounts they’ve accumulated in their retirement accounts. Corporations too will face the same shock as shortfalls in pension plan accumulations will have profoundly negative implications for their financial statements.”
Instead of rising to $743,000, that $10,000 investment would only rise to $44,000, he said. Not including taxes.
And retired public employees? They’ll be fine. They many have gotten retroactive pension enhancements far beyond what they were promised when they were hired, the deals may have been done in the dark, and the union-vetted actuaries may have lied about the consequences of the deals in exchange for their commissions. But the pensions are still readily affordable. All that is required is to eliminate public services. And in the dark and off the books, that is what has been going on – and is going to get much worse for a decade or two.
Now I want to elaborate on the point about price appreciation and dividends. Consider General Electric, the subject of Mr. Nunes’s last post. It is the bluest of the blue chip, the safest and most reliable stock, it was believed. But at the peak of the stock market bubble in 2000 it was worth 60 dollars per share and now, after the bubble partially deflated and all the extra stock was issued to executives in the form of options and bonuses, it is worth 20. Which means that any pension fund or 401K plan holding GE lost one-third of its money. Or has it?
Said Bogle “one of the principal problems of today’s financial markets” is “the idea that shareholder value is represented by stock price. Not so. The value of a stock is represented by the discounted value of its future cash flow. Yet market participants have come to believe that the momentary precision reflected in the price of a stock is more important than the eternal imprecision of measuring the intrinsic value of a corporation. Prices can rise far above their intrinsic values – or far below – but the pendulum finally centres on fair value.” Well not yet, it’s still too high, but you get the picture.
GE really wasn’t worth 60 in 2000. But lots of executives got paid as if it was, and are still getting paid as if it was. And lots of retroactive pension deals were cut as if it was. And are still in force, irrevocably, forever, regardless of the consequences for others.
The current dividend yield for GE is 3.0%, less than the 4.5% historical average but still more than most stocks. But if GE stock still sold for three times as much with the same dividends, that yield would only be 1.0%. On the other hand, if you knocked another 1/3 off the value of GE stock, the same amount of dividends would produce a dividend yield of 4.5%, the historical average. If stock prices are inflated, in other words, you have to expect a lower return going forward. And most stock prices are currently even more inflated that GE right now. Either the high stock prices are real, or the historical rate of inflation adjusted return can be achieved going forward. Not both.
Moreover, counting on price appreciation to pay for pensions means the funds are going to pay the pensioners by selling off their assets. Which is exactly what has been happening. But what, then, will be used to pay future pensioners? We are gearing up to screw younger and future public employees, nationwide. As a matter of “fairness,” since younger and future workers are so much worse off in the private sector too, in order to fund what Generation Greed has promised itself but refused to pay for.
But let’s say the pension funds are not going to sell off all the stocks. That makes them the long term owners, and current and future dividends is all they will ever get. So why don’t they, as owners, demand that executives pay themselves less and use the savings for dividends, rather than running the companies in their own self interest as an interlocking cabal?
According to another recent FT article “the agency problem has dogged the publicly quoted company since its invention. Adam Smith identified the separation of management and ownership as one of the reasons for the South Sea Company’s collapse in 1720. Given the number of the company’s shareholders, he argued, it was to be expected that ‘folly, negligence and profusion should prevail in the management of their affairs.’”
Why don’t shareholders act in their own interest? “Most of the reasons institutions give for shying away from activism are poor ones. They claim to lack the skills to hold management to account, or to dislike the publicity. Some argue that the time and costs incurred are too great, and that they would rather free-ride on others. But that is an argument for collaboration…rather than passivity. Some simply have conflicts of interest; they worry that activism could reduce their chance of winning pension fund mandates.”
There it is, the last one. We don’t own companies directly. We give money to Wall Street, run by the same Executive Class that runs the other companies, with a “you scratch my back I’ll scratch yours” relationship with others of their type. Or to politicians such as Alan Hevesi, who distribute money in exchange for campaign contributions or worse. It isn’t “folly, negligence and profusion” from their point of view, or from the point of view of the public employee unions. It is a very good deal for their crowd, at everyone else’s expense.
The historical dividend yield includes a long period during and after the Great Depression, when people were skeptical of stocks, preferred to keep their money in the bank, and had to be convinced to buy shares. Convinced by lower paid, modest, decent seeming executives and fat payouts. And yet after 20 years of growing executive pay and arrogance and falling investor returns, someone is still buying stocks. With other people’s money. The best that I can say for stocks is they might do better than bonds, giving the hosing that may coming due to rising either rising interest rates or defaults depending on what happens to inflation. But the return will be vastly lower than assumed by most public employee pension funds for both.
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