The croupier’s take
The greatest problem facing equity investors today is not the bear market or the weakness of the global economy. Nor has it anything to do with the possibility of war, high levels of corporate and consumer indebtedness, or any of the other problems one reads about regularly in the business pages. The real problem is the low levels of expected returns for most stock market investors. This is due primarily to the high levels of fees extracted by a bloated and parasitic financial services industry. Charlie Munger, the right-hand man of Warren Buffett, refers to these fees as the “croupier’s take.” Let us attempt to gauge its size.
As a starting point, I suggest that the stock market’s future return will be 5 per cent after inflation. This figure is somewhat lower than the historical average but appears prudent in the post-bubble environment. The croupier’s take begins at the corporate level. First, we have the extraordinary compensation of senior executives in the form of stock options. In the US, according to Standard & Poor’s, these were equal to 20 per cent of reported earnings in the 12 months ending June 2002. Bang goes one fifth of expected shareholder returns. We estimate, very roughly, that the fees paid by corporations to investment banks for mergers and acquisitions and other services knock a further 0.5 percentage point off expected returns.
Now let us consider the various charges of the fund management industry. Managers of corporate pension funds normally charge a fee of around 0.5 per cent. On top of this we must add the costs of trading. These include commissions to brokers and stock exchanges, and the “spread” between the bid and offer price of shares. I assume that these costs are roughly 1 per cent of transaction value. US investors pay an average of $30 billion each year in brokerage commissions. Thus, a fund manager with an average holding period of one year accrues annual costs of 1 per cent to clients. After this, our expected returns have fallen to a mere 2 per cent.
It gets worse for retail investors. They face up-front charges when buying mutual funds of up to 7 per cent and attract higher management fees, averaging around 1.3 per cent. Additional costs give the average mutual fund a total expense ration of 2.3 per cent. As the western world moves from defined benefit pensions run by cost-conscious employers to defined contribution schemes where investment decisions are made by employees, this level of charges is becoming commonplace. Finally, there is taxation to consider: in Britain, stock purchases attract stamp duty at 0.5 per cent and in the US, mutual funds pay capital gains on their trading profits.
As a result of these charges, the expected equity return today for the retail investor drops to around 1 per cent. This not far-fetched. According to the Leuthold Group, the average stock market return for mutual fund investors between 1984 and 2000 was around 5 per cent per annum, against an overall market return of more than 16 per cent. Thus, during the greatest ever bull market, a combination of the croupier’s take and poor investment decisions cost the mutual fund investor more than 11 percentage points a year in lost returns.
With the financial services industry today consuming up to four-fifths of expected returns, why bother saving for retirement? The general public seems to realise this-that is why it is busy spending every last penny.
Keynes’s forced savings plan
The croupier’s take does not in itself explain why Britain and the US have such exceptionally low savings rates. This is largely a consequence of the late 1990s boom when people believed the stock market would do their saving for them. Now, the Anglo-Saxon countries face a problem. They need to increase savings, but if they do so then economic growth will slump. Keynes referred to this as the “paradox of thrift.” It is a problem which could have been avoided had another idea of the great economist been applied during the last decade.
In the early stages of the second world war, Keynes struggled with the twin problems of how to curb excess consumer demand at a time when real disposable income was climbing and raise money for the government whilst avoiding the disincentives caused by penal rates of taxation. He suggested that Britain should adopt a system of “compulsory saving.” Under this scheme, part of the wage packet would be paid via the administration of National Insurance into the Post Office Savings Bank, where it would be blocked. After the war, the money would be returned, thereby increasing demand during the inevitable slump.
In 1955, the British colonial administrators of Singapore introduced a national savings scheme which has some of the characteristics of Keynes’s plan. Employees and employers were initially required to pay 5 per cent each of the employee’s pay packet into his or her account. Manipulation of the savings rate in Singapore became a tool of demand management.
The Anglo-Saxon economies would have benefited from such a forced savings system during the late 1990s. During the boom, as investment and consumption soared, the trade deficit gaped and savings deteriorated, the authorities would have been in a position to force up the rate of savings. This would have been the equivalent of a tax hike but not as politically unpopular. Had this occurred, the macroeconomic imbalances which still threaten recovery might have been kept in check.