Wealth Disparity Executives as Owners vs. Executives

Wealth Disparity

Executives as owners vs. Executives as representatives

Stock Options on wage growth

Taxes on wage growth

Inflation on wage growth

Individual Wealth Education (Mutual Fund Fallacy)

Financial Education

A very contentious issue arising within public domain is that of compensation and its repercussions on overall society. Over the past 3 decades executive compensation has ballooned while the average worker continues to see only modest gains in income. The average annual earnings of the top 1% of wage earners grew 156% from 1979 to 2007; for the top 0.1% they grew 362% (Mishel, Bivens, Gould, and Shierholz 2012). In contrast, earners in the 90th to 95th percentiles had wage growth of 34%, less than a tenth as much as those in the top 0.1% tier. Workers in the bottom 90% had the weakest wage growth, at 17% from 1979 to 2007. If inflation averaged just 2% a year over this period, the gains of the bottom 90% would be negative. In 2007, average annual incomes of the top 1% of households were 42 times greater than in-comes of the bottom 90%, and incomes of the top 0.1% were 220 times greater. This is an increase of 1400% and 4700% respectively since 1979.

An answer to this question pertains mainly to management as owners vs. management as representatives. This statement may seem one in the same but prior to 1990, management's duties and responsibilities where polar opposite to those of today. In the 1980's management was seen primarily as a "representative" of the entire business entity. As a result, stockholder and investor interests where junior to the needs of the overall business. Managers did not use assets in a manner is which stakeholders benefited. In fact, most management was inclined to underuse capacity. Companies with competitive advantages such as economies of scale or distribution networks simply did not use them to their fullest extent. This benefited the manager who had compensations packages that were based very loosely on metrics that can be easily manipulated. This metrics included revenue, earning per share, and sales growth (Kaplan, 2012). All management had to do was to simply alter assumptions within the annual report to "create" earnings or manipulate earnings as their compensation was not in the form of stock. For example, one method earnings that can be "created" or "manufactured" is by manipulating the pension fund assumptions in the annual report. By "expecting" a higher growth rate within the pension fund, a company can contribute fewer earnings to fund the pension. These pension savings are then transferred to the bottom line as a profit increase, when in reality; the increase was a result of accounting gimmicks (Shaw, 2012). Such was the case in the 1980's as many companies used these gimmicks to manipulate financial information. To be fair, the 1980's and prior decades where marked with economic uncertainties that created a sense of caution among businesses. This cautious attitude can reasonably attribute to the notion of unutilized capacity. However, this underused capacity was still a detriment to shareholders as costs per unit and overhead per unit increases due to this unused capacity. What would eventually ensure was a wave of hostile takeovers and proxy fights in an effort to better align corporate goals with those of its owners. Many investors who found companies with assets that where not utilized to their fullest potential would simply obtain a majority stake in the business and either sale or use those assets to generate profits or cash. Companies began to take notice and began to better align corporate objectives with owner objectives through the issuance of stock options.

These stock options contribute heavily to the income disparity between executives and the average worker. First, in many instances the executive gains at the expense of the shareholder through the issuance of stock options. Furthermore, these options often times encourage extreme risk taking on the part of the executive which ultimately increases the executive's wealth at the expense of the long-term oriented shareholder. These shareholders are often those in the bottom 90% looking to gain dividend income and increase their own wealth.

This stock option grant problem is two fold in nature. First, where do these options come from? They simply are not created from thin air. Instead they are issued by the corporation in which the executive works. This is a very detrimental to the average shareholder of the company who overwhelming consist of individuals in the bottom 90%. When a company issues stock options to executives, it reduces the ownership stake of all the other owners of the business. The more shares outstanding that are issued, without a corresponding increase in earnings results in less earning per share for the average shareholder. This action ultimately increases executive wealth at the expense of the shareholder.

Even more alarming is that these options are given to executives at a discount to their intrinsic value. For example if a share is trading at $50 in the open market, an executive might be given the option for 100,000 shares at $20 fore each share. In essence, the executive is getting a $5 million piece of the company for only $2 million. As I mentioned above, these nearly issued shares take away ownership claims of the average shareholder. In addition, the shareholders will ultimately end up paying the $3 million dollar difference. Again, as was the case above, the executive benefits at the expense of the shareholder. Shareholders are literally giving pieces of the company away to executives at less value than they are worth in the market.

Shareholders have recently contested stock options very aggressively in light of recent events. Executives are being compensated without a corresponding increase in business value. As such, shareholders are limited or simply not approving executive compensation packages. I agree with this approach and believe shareholders should act more like owners of a particular enterprise. If owners begin to voice their concerns through proxy votes, I believe a sustainable change in regards to executive compensation will occur.

Another very important aspect to consider is that of taxes. Taxes are a detriment to wealth and income creation. Therefore, it is logically for an American citizen to reduce this burden in creating future wealth. The current tax system however, is heavily favored towards those with extreme incomes. Many of the wealthiest individuals in society are taxed at rates far lower than those of the median income earner. Below is a chart depicting the tax rates of the 400 wealthiest Americans. Notice how their rate is diminished substantially over the 12-year period.

Next is a chart depicting the tax rates based on income level. Again, notice the large decline in tax rates from the wealthiest group of Americans. Meanwhile, the remaining group of American tax payers realized no such decline in their rates but in many instances saw a minor increase in rates.

I believe the income gap can be attributed to many factors related solely to tax considerations. First, as noted by the above charts, larger wage earners are retaining more of their earnings. These earnings are then reinvested at the prevailing market rate to earn more money for these individuals in the future. In addition, the taxes for the wealthy come in the form of capital gains tax, which subsequently are 15%. Not only are more of the wealthiest individuals retaining a larger portion of their income, they are, in their prudence, reinvesting these earning for even more tax benefits. This behavior is logical and is very intelligent. However, many individuals in lower income brackets simply do not have those same opportunities. In fact, they are burdened more so than their wealthier counterparts. For one, they can not save or invest the same sums of money wealthier individuals can on a percentage of income basis simply because their tax rate is disproportionally higher. Therefore, they will not be able to achieve the same degree of benefit from the lower capital gains tax. This ultimately contributes to the income gap as wealthier individuals in percentage terms, can simply invest more of their income relative to their lower income peers. Furthermore, a vast majority of the top wage earners garner their wages from dividend income which again is -- you guessed it- taxed at 15%. Middle income earners do not have this same benefit as many of their earnings are taxed at the 25% average rate.

In addition, the cost of living, along with inflation continues to rise faster than wage increased for the middle class. This is particularly important as the U.S. government is forcing large amounts of dollars into circulation. At sum point in the future, inflation will have an effect on the cost of living. This provides two distinct problems in regards to income inequality. First, the purchasing power of the average American citizen will be diminished. As such, the amount of assets the individual can purchase will decrease at a corresponding amount. However, the top wage earners have their money tied to claims on tangible assets. A stock is, in part, a claim on the companies earning assets. These assets tend to rise with inflation. Thus, the large wage earnings of society can retain their purchasing power. The lower wage earners of society will therefore be at a disadvantage once again as his dollars are losing purchasing power while his wealthy counterparts maintain and in many instances gain purchasing power. As such, the income gap again widens at the expense of the middle to lower class.

A discussion on taxes in regards to mutual funds and other forms of assets is also warranted within the context of wealth creation. Not only through federal, state, and local taxes are lower wage earner incomes being significantly diminished but there is also another tax hidden in mutual funds- expense ratios. These expenses that many executives do not pay contribute heavily to the burgeoning gap of wage disparity. The public is lead to believe through a series of marketing gimmicks, that the mutual fund is great way to save for retirement. I have no quarrels about this assertion. In fact I agree with the general premise of mutual funds. However, the high fees they command only inhibit the wealth creation of average American. A better alternative would be that of an index fund which has significantly less expenses. This misconception and lack of education partly contributes to the ever widening gap of income between executives and the rest of society.

A major contribution to the disparity that is currently occurring in the United States is that of education and emotional intelligence. There are many avenues in which the average retail investor loses money to the delight of executives. One such aspect of education comes from mutual funds and the fallacy of excess returns. First the notion of costs makes the index fund far superior to that of the mutual fund (Kennen, 2012). In many instances, mutual fund investors must a fee simply for the expertise of the manager. This fee, called the expense ratio can be anywhere from 1.5% to upwards of 3% of the funds assets. As mentioned earlier, these fees are paid irrespective of the actual performance of the mutual fund (Much like the stock options mentioned above). If the fund losses 10% in one year, an investor still pays the expense ratio. In addition, there are also investment advisory or management fees that must be paid. These fees can range from .5% to 1% of the funds assets. There are administrative fees which are used for mailing correspondence and prospectuses to individual or potential investors. These fees too can range from as low as .2% to 1% of assets managed. Finally, there are fees called 12b-1 fees which are often hidden from the individual investor. These fees are usually used for promotional purposes in which to obtain more inflows of cash to manage so they can charge more fees ( Mutual Fund Expense, 2012). This process is repeated and eventual the fund grows to gargantuan proportions. How does this fee aid in wealth accumulation for the individual investor? It does NOT and in fact, as I shall show, it detracts from wealth accumulation. Instead, it is simply a transfer of wealth from those who pay the fees to those who impose them, nothing more, and nothing less. This creates an income gap as a larger proportion of the investors income goes to other parties that ordinarily don't benefit the investor. As you can see, executives and mutual fund managers have incentive to build large asset bases which as I mentioned above. The bigger the asset base, the more the mutual fund can retain in fees and hidden expenses. However, the bigger the asset base the harder it is growing above the benchmark index. In order to outperform the index fund the mutual fund must obtain at least a return that is higher than the index funds return PLUS the combined fees. On the low end, these funds can be approximately 3%. So for example, if the S&P 500 obtained a return of 10% the mutual fund would have to return at least 13% just to be breakeven. To the untrained eye, 3% may seem of very little importance. However, a 3% disparity can in fact have a very profound impact on the saving and income of a small investor. To prove this point, I have provided a CHART 1 which depicts the actual dollar amount lost with various expense ratios over a 30-year time horizon. 30 years was chosen because that is generally the work life of a typical middle class American. Place particular emphasis on the yellow portions of the chart. These are the most alarming of all.

How to read the chart:

Chart 1 assumes a 10% growth rate of a mutual fund over a 30-year time horizon. The expense ratios at the top of the chart vary from .5% to 2.5% (which is very modest indeed!) The chart is broken down into 3, 10-year segments. At the end of each segment, highlighted in yellow is the amount of money lost solely from the expense ratio, and the % of this loss relative to the actual gain if no expense was present. (By the way, any individual investor can construct a similar graph to the one I created by using the excel FV function. It takes a very minimal amount of time and be very insightful)

CHART 1

Expense Ratio

Years

10% Gain

$ Less

($1,155)

($2,264)

($3,328)

($4,348)

($5,327)

% Less

$ Less

($5,859)

($11,231)

($16,155)

($20,665)

($24,796)

% Less

$ Less

($22,291)

($41,817)

($58,912)

($73,867)

($86,944)

% Less

-12.80%

-24%

-33.80%

-42.30%

-49.80%

As you can see the chart is very insightful indeed! Over a 30-year time horizon, assuming 10% growth, the investor would ordinarily gain $174,494. However due to the expense ratio the investor would only gain $87,550. This is nearly a 50% decline in dollar terms. Now as an investor this is alarming on multiple fronts. The investor is putting up 100% of the capital, taking 100% of the risk, but only obtaining 50% of the benefit! That to me is not a good investment.

So where does the other 50% of the investors return go? Well, just as the stock options mentioned earlier erode wealth from the investor, so too does the mutual fund. The other 50% of the investors return was "stolen" through fees and administrative costs. This is where lack of individual financial education reveals and excessive marketing gimmick collide. The average American is very much aware of the concept of compounding interest (The chart above is an example). However, many are unaware of compounding expenses. The same way returns can compound for the investors benefit, so too can the expenses compound to the investors detriment. This stolen money ultimately flow into the handles of financial firms in the form of- brace yourself - more stock options for executives and management. The cycle continues until we reach the point the nation is at today. The financial savvy executives and financial managers hold a disproportionate amount of the wealth, at the expense of the rest of society. I suspect, even if stiffer taxes are imposed on the wealth, the fundamental premise of lack of education will still remain. As such, the trend of wealth accumulation for the wealthy will undoubtedly continue to occur. This ultimately will lead to ever widening gaps in income of executives and the working middle class.

Are escalating executive salaries justified or not? If so, what are the implications for wage growth for other workers? To answer this question appropriately one would need to look at each company on an individual basis. Some companies in regards to their breadth of services, knowledge and business operations, require that their executives be compensated commensurate with their span of control. Likewise smaller businesses will have slower growth in their executive salaries relative to their peers. More consideration should be given to the underlying business economics that govern a particular executives business. For example, in the case of banking, the salaries of John G. Stumpf (Wells Fargo) and Jamie Dimon (JP Morgan) are justified. In regards to Wells Fargo, they have captured enormous market share in the midst of the global recession. Currently, Wells originates 33% of all mortgages in the United States. This figure has increased every year since the great recession. The nearest competitor is JP Morgan at 10.6% (Shenn, 2012). Thanks in part to Stumpf's leadership, the company has widened its lead on mortgage originations to the point that it is triple the nearest competitor. This figure is important as housing begins to rebound in the United States. Wells Fargo will be in the best position to take advantage of the rebound. John Stumpf should therefore be rewarded accordingly. His compensation is justified by the performance of the company in regards to economic circumstances which govern it. There should be no quarrels with this form of compensation.