The Great Stock Illusion

The enormous paper wealth "created" by the stock market was bound to dissolve, because it never existed, save as a kind of mass delusion.

ELLEN FRANK

During the 1980s and 1990s, the Dow Jones and Standard & Poor's indices of stock prices soared ten-fold. The NASDAQ index had, by the year 2000, skyrocketed to 25 times its 1980 level. Before the bubble burst, bullish expectations reached a feverish crescendo. Three separate books—Dow 36,000, Dow 40,000 and Dow 100,000—appeared in 1999 forecasting further boundless growth in stock prices. Bullish Wall Street gurus like Goldman's Abby Cohen and Salomon's Jack Grubman were quoted everywhere, insisting that prices could go nowhere but up.

But as early as 1996, skeptics were warning that it couldn't last. Fed chair Alan Greenspan fretted aloud about "irrational exuberance." Yale finance professor Robert Shiller, in his 2001 book titled Irrational Exuberance, insisted that U.S. equities prices were being driven up by wishful thinking and self-fulfilling market sentiment, nourished by a culture that championed wealth and lionized the wealthy. Dean Baker and Marc Weisbrot of the Washington-based Center for Economic and Policy Research contended in 1999 that the U.S. stock market looked like a classic speculative bubble—as evidence they cited the rapidly diverging relationship between stock prices and corporate earnings and reckoned that, to justify the prices at which stocks were selling, profits would have to grow at rates that were frankly impossible.

In 1999 alone, the market value of U.S. equities swelled by an astounding $4 trillion. During that same year, U.S. output, on which stocks represent a claim, rose by a mere $500 billion. What would have happened if stockholders in 1999 had all tried to sell their stock and convert their $4 trillion into actual goods and services? The answer is that most would have failed. In a scramble to turn $4 trillion of paper gains into $500 billion worth of real goods and services, the paper wealth was bound to dissolve, because it never existed, save as a kind of mass delusion.

The Illusion of Wealth Creation

Throughout the 1990s, each new record set by the Dow or NASDAQ elicited grateful cheers for CEOs who were hailed for "creating wealth." American workers, whose retirement savings were largely invested in stocks, were encouraged to buy more stock—even to bet their Social Security funds in the market—and assured that stocks always paid off "in the long run," that a "buy-and-hold" strategy couldn't lose. Neither the financial media nor America's politicians bothered to warn the public about the gaping disparity between the inflated claims on economic output that stocks represented and the actual production of the economy. But by the end of the decade, insiders saw the writing on the wall. They rushed to the exits, trying to realize stock gains before the contradictions inherent in the market overwhelmed them. Prices tumbled, wiping out trillions in illusory money.

The case of Enron Corp. is the most notorious, but it is unfortunately not unique. When Enron filed for bankruptcy protection in November of 2001 its stock, which had traded as high as $90 per share a year before, plummeted to less than $1. New York Times reporter Jeffrey Seglin writes that the elevators in Enron's Houston headquarters sported TV sets tuned to CNBC, constantly tracking the firm's stock price and acclaiming the bull market generally. As Enron stock climbed in the late 1990s, these daily market updates made employees—whose retirement accounts were largely invested in company shares—feel quite wealthy, though most Enron workers were not in fact free to sell these shares. Enron's contributions of company stock to employee retirement accounts didn't vest until workers reached age 50. For years, Enron had hawked its stock to employees, to pension fund managers, and to the world as a surefire investment. Many employees used their own 401(k) funds, over and above the firm's matching contributions, to purchase additional shares. But as the firm disintegrated amid accusations of accounting fraud, plan managers froze employee accounts, so that workers were unable to unload even the stock they owned outright. With employee accounts frozen, Enron executives and board members are estimated to have dumped their own stock and options, netting $1.2 billion cash—almost exactly the amount employees lost from retirement accounts.

Soon after Enron's collapse, telecommunications giant Global Crossing imploded amid accusations of accounting irregularities. Global Crossing's stock, which had traded at nearly $100 per share, became virtually worthless, but not before CEO Gary Winnick exercised his own options and walked away with $734 million. Qwest Communications director Phil Anschutz cashed in $1.6 billion in the two years before the firm stumbled under a crushing debt load; the stock subsequently lost 96% of its value. The three top officers of telecom equipment maker JDS Uniphase collectively raked in $1.1 billion between 1999 and 2001. The stock is now trading at $2 per share. An investigation by the Wall Street Journal and Thompson Financial analysts estimates that top telecommunications executives captured a staggering $14.2 billion in stock gains between 1997 and 2001. The industry is now reeling, with 60 firms bankrupt and 500,000 jobs lost. The Journal reports that, as of August 2002, insiders at 38 telecom companies had walked away with gains greater than the current market value of their firms. "All told, it is one of the greatest transfers of wealth from investors—big and small—in American history," reporter Dennis Berman writes. "Telecom executives … made hundreds of millions of dollars, while many investors took huge, unprecedented losses."

Executives in the energy and telecom sectors were not the only ones to rake in impressive gains. Michael Eisner of Disney Corp. set an early record for CEO pay in 1998, netting $575 million, most in option sales. Disney stock has since fallen by two-thirds. Lawrence Ellison, CEO of Oracle Corp., made $706 million when he sold 29 million shares of Oracle stock in January 2001. Ellison's sales flooded the market for Oracle shares and contributed, along with reports of declining profits, to the stock's losing two-thirds of its value over the next few months. Between 1999 and 2001, Dennis Koz_lowski of Tyco International sold $258 million of Tyco stock back to the company, on top of a salary and other compensation valued near $30 million. Kozlowski defended this windfall with the claim that his leadership had "created $37 billion in shareholder wealth." By the time Kozlowski quit Tyco under indictment for sales tax fraud in 2002, $80 billion of Tyco's shareholder wealth had evaporated.

Analyzing companies whose stock had fallen by at least 75%, Fortune magazine discovered that "executives and directors of the 1035 companies that met our criteria took out, by our estimate, roughly $66 billion."

The Illusion of Retirement Security

During the bull market, hundreds of U.S. corporations were also stuffing employee savings accounts with corporate equity, creating a class of captive and friendly shareholders who were in many cases enjoined from selling the stock. Studies by the Employee Benefit Research Council found that, while federal law restricts holdings of company stock to 10% of assets in regulated, defined-benefit pension plans, 401(k)-type plans hold an average 19% of assets in company stock. This fraction rises to 32% when companies match employee contributions with stock and to 53% where companies have influence over plan investments. Pfizer Corporation, by all accounts the worst offender, ties up 81% of employee 401(k)s in company stock, but Coca-Cola runs a close second with 76% of plan assets in stock. Before the firm went bankrupt, WorldCom employees had 40% of their 401(k)s in the firm's shares. Such stock contributions cost firms virtually nothing in the short run and, since employees usually aren't permitted to sell the stock for years, companies needn't worry about diluting the value of equity held by important shareholders—or by their executive option-holders. Commenting on recent business lobbying efforts to gut legislation that would restrict stock contributions to retirement plans, Marc Machiz, formerly of the Labor Department's retirement division, told the Wall Street Journal, "business loves having people in employer stock and lobbied very hard to kill this stuff."

Until recently, most employees were untroubled by these trends. The market after all was setting new records daily. Quarterly 401(k) statements recorded fantastic returns year after year. Financial advisers assured the public that stocks were and always would be good investments. But corporate insiders proved far less willing to bank on illusory stock wealth when securing their own retirements.

Pearl Meyer and Partners, an executive compensation research firm, estimates that corporate executives eschew 401(k) plans for themselves and instead negotiate sizable cash pensions—the average senior executive is covered by a defined-benefit plan promising 60% of salary after 30 years of service. Under pressure from the board, CEO Richard McGinn quit Lucent at age 52 with $12 million in severance and a cash pension paying $870,000 annually. Lucent's employees, on the other hand, receive a 401(k) plan with 17% of its assets invested in Lucent stock. The stock plunged from $77 to $10 after McGinn's departure. Today it trades at around $1.00. Forty-two thousand Lucent workers lost their jobs as the firm sank.

When Louis Gerstner left IBM in 2002, after receiving $14 million in pay and an estimated $400 million in stock options, he negotiated a retirement package that promises "to cover car, office and club membership expenses for 10 years." IBM's employees, in contrast, have been agitating since 1999 over the firm's decision to replace its defined benefit pension with a 401(k)-type pension plan that, employee representatives estimate, will reduce pensions by one-third to one-half and save the firm $200 million annually. Economist Paul Krugman reports in the New York Times that Halliburton Corp. eliminated its employee pensions; first, though, the company "took an $8.5 million charge against earnings to reflect the cost of its parting gift" to CEO Dick Cheney. Business Week, surveying the impact of 401(k)s on employee retirement security, concludes that "CEOs deftly phased out rich defined-benefit plans and moved workers into you're-on-your-own 401(k)s, shredding a major safety net even as they locked in lifetime benefits for themselves."

Since 401(k)s were introduced in the early 1980s their use has grown explosively, and they have largely supplanted traditional defined-benefit pensions. In 2002, three of every four dollars contributed to retirement accounts went into 401(k)s. It is thanks to 401(k)s and other retirement savings plans that middle-income Americans became stock-owners in the 1980s and 1990s. It is probably also thanks to 401(k)s, and the huge demand for stocks they generated, that stock prices rose continuously in the 1990s. And it will almost certainly be thanks to 401(k)s that the problems inherent in using the stock market as a vehicle to distribute income will become glaringly apparent once the baby-boom generation begins to retire and liquidate its stock.

If stocks begin again to rise at historical averages—something financial advisors routinely project and prospective retirees are counting on—the discrepancy between what the stock market promises and what the economy delivers will widen dramatically. Something will have to give. Stocks cannot rise faster than the economy grows, not if people are actually to live off the proceeds.

Or rather, stock prices can't rise that fast unless corporate profits—on which stocks represent a legal claim—also surpass GDP gains. But if corporate earnings outpace economic growth, wages will have to stagnate or decline.

Pension economist Douglas Orr believes it is no accident that 401(k)s proliferated in a period of declining earnings and intense economic insecurity for most U.S. wage-earners. From 1980 until the latter half of the 1990s, the position of the typical American employee deteriorated noticeably. Wages fell, unemployment rose, benefits were slashed, stress levels and work hours climbed as U.S. firms "downsized" and "restructured" to cut costs and satiate investor hunger for higher profits. Firms like General Electric cut tens of thousands of jobs and made remaining jobs far less secure in order to generate earnings growth averaging 15% each year. Welch's ruthless union-busting and cost-cutting earned him the nickname "Neutron Jack" among rank-and-file employees. GE's attitude towards its employees was summed up by union negotiator Steve Tormey: "No matter how many records are broken in productivity or profits, it's always 'what have you done for me lately?' The workers are considered lemons and they are squeezed dry." Welch was championed as a hero on Wall Street, his management techniques widely emulated by firms across the nation. During his tenure, GE's stock price soared as the firm slashed employment by nearly 50%.

The Institute for Policy Studies, in a recent study, found that rising stock prices and soaring CEO pay packages are commonly associated with layoffs. CEOs of firms that "announced layoffs of 1000 or more workers in 2000 earned about 80 percent more, on average, than the executives of the 365 firms surveyed by Business Week."

Throughout the 1980s and 1990s, workers whose jobs were disappearing and wages collapsing consoled themselves by watching the paper value of their 401(k)s swell. With labor weak and labor incomes falling, wage and salary earners chose to cast their lot with capital. In betting on the stock market, though, workers are in reality betting that wage incomes will stagnate and trying to offset this by grabbing a slice from the profit pie. This has already proved a losing strategy for most.

Even at the peak of the 1990s bull market, the net wealth—assets minus debts—of the typical household fell from $55,000 to $50,000, as families borrowed heavily to protect their living standards in the face of stagnant wages. Until or unless the nation's capital stock is equitably distributed, there will always be a clash of interests between owners of capital and their employees. If stocks and profits are routinely besting the economy, then either wage-earners are lagging behind or somebody is cooking the books.

Yet surveys show that Americans like 401(k)s. In part, this is because savings accounts are portable, an important consideration in a world where workers can expect to change jobs several times over their working lives. But partly it is because savings plans provide the illusion of self-sufficiency and independence. When retirees spend down their savings, it feels as if they are "paying their own way." They do not feel like dependents, consuming the fruits of other people's labor. Yet they are. It is the nature of retirement that retirees opt out of production and rely on the young to keep the economy rolling. Pensions are always a claim on the real economy—they represent a transfer of goods and services from working adults to non-working retirees, who no longer contribute to economic output. The shift from defined-benefit pensions to 401(k)s and other savings plans in no way changes the fact that pensions transfer resources, but it does change the rules that will govern how those transfers take place—who pays and who benefits.

Private defined-benefit pensions impose a direct claim on corporate profits. In promising a fixed payment over a number of years, corporations commit to transfer a portion of future earnings to retirees. Under these plans, employers promise an annual lifetime benefit at retirement, the amount determined by an employee's prior earnings and years of service in the company. How the benefit will be paid, where the funds will come from, whether there are enough funds to last through a worker's life—this is the company's concern. Longevity risk—the risk that a worker will outlive the money put aside for her retirement—falls on the employer. Retirees benefit, but at a cost to shareholders. Similarly, public pension programs, whether through Social Security or through the civil service, entail a promise to retirees at the expense of the taxpaying public.

Today, the vast majority of workers, if they have pension coverage at all, participate in "defined contribution" plans, in which they and their employer contribute a fixed monthly sum and invest the proceeds with a money management firm. At retirement, the employee owns whatever funds have accrued in the account and must make the money last until she dies. Defined-contribution plans are a claim on nothing. Workers are given a shot at capturing some of the cash floating around Wall Street, but no promise that they will succeed. 401(k)s will add a huge element of chance to the American retirement experience. Some will sell high, some will not. Some will realize gains. Some will not.

Pearl Meyer and Partners estimate that outstanding, unexercised executive stock options and employee stock incentives today amount to some $2 trillion. Any effort to cash in this amount, in addition to the stock held in retirement accounts, would have a dramatic impact on stock prices. American workers and retirees, in assessing their chances for coming out ahead in the competition to liquidate stock, might ponder this question: If, as employees in private negotiations with their corporate employers, they have been unable to protect their incomes or jobs or health or retirement benefits, how likely is it that they will instead be able to wrest gains from Wall Street where corporate insiders are firmly in control of information and access to deals?

This article is adapted from the author's forthcoming book.

Ellen Frank teaches economics at Emmanuel College and is a member of the Dollars & Sense collective.