US ECONOMIC OUTLOOK: EQUITY-BASED COMPENSATION EFFECT ON PERSONAL SAVING RATE


Chart 1 Saving Rate - US Economic Outlook Compensation

Chart 1 Saving Rate

This article explains the main reasons behind the declining trend of personal saving rate in United States for over two decades. “Savings” is defined by setting aside some earned funds and reserving them for future consumption. Regarding Federal Reserve’s Flow of Fund Account (FOF) calculation, the personal saving to disposable income ratio decreased from 10% in 1980 to a negative number in 2000. A negative one percent personal saving ratio indicates that for every $100 after-tax income (disposable income), U.S. consumers are spending $101 by borrowing $1 annually. Therefore, many analysts believe that households are not saving enough to provide a sustainable economic growth without using foreign capital resources.The aging population of America is the main concern of the low rate.6For the following 20 years, the population of 60- year-old people will increase much more according to corresponding demographics. The baby-boomer generation is approaching their retirement age and this will bring additional burdens on the government’s budget due to increased Social Security and Medicare program payments.7 Therefore, economists suggest that a higher personal saving ratio will provide a higher domestic capital stock, which will decrease such burdens and increase the output per worker. A study by Harvard University and National Bureau of Economic Research (“NBER”) showed both capital-exporting countries and capital-importing countries were fearful of the result of international capital flow.8 Hence, after 1980, politicians have been eager to intervene with the free market system by imposing tax and interest incentives to bring the saving rate to normal levels.

We see in Chart 1 that the savings rate is in a downward trend between 1985 and 2005. Many economists try to explain this phenomenon by suggesting reasons such as the rising confidence of the society, the wider availability of funds in credit markets and the higher level of e-capital of individuals.6Yet we consider these factors to be results of the development and growing sophistication of the financial systems in the United States. Further we believe that this downward trend cannot be explained by irrational behavior of U.S. households, as it is often argued that households consume more than they earn or do not plan for their future. In fact, U.S. households are very rational in spending because they have funds which are not taken into account as a part of disposable income calculation.

Especially since 1980s, U.S. businesses have been encouraged to augment compensation packages to include equity vehicles in order to increase a stake in the “ownership society.” If we look at the personal saving rate fluctuations on Chart 1, the FOF, we can conclude that the biggest fall in rates had been experienced before the stock market had its historical highest levels in 2000 and 2005-2006. When stock market valuations increase there is a correlating personal savings rate decrease; the urgency to reserve cash is offset by the increased value of employees’ equity-based vehicles.  Therefore, in this paper, we focus on the problems inherent in the methods of measuring so-called low savings rates rather than the corresponding effects of low rates. We believe that the huge decline in the savings rate after 1980s is basically due to the negligence of the changing parameters which would otherwise be added to the calculations to yield a more accurate result. Yet, we want to define the current methods before we go through our suggestions.

According to the NBER, the personal savings rate is calculated as the disposable income minus consumption expenditures, and divided again by disposable income, or the National Income and Product Account (“NIPA”).

Where disposable income is defined as the total personal income minus personal current taxes, consumption expenditures is the total amount of durable, non-durable goods and services consumed during a year. However, this definition of disposable income does not include the equity-based compensation received by the employees in terms of employee stock options (“ESOs”), restricted stock units (“RSUs”), stock appreciation units (“SAUs”), and stock appreciation rights (“SARs”).3Additionally, neither the real-estate investments of households nor their capital gains are taken into consideration.

The second method to calculate the personal saving ratio is the Federal Reserve’s Flow of Funds formula (“FOF”):

Personal Saving = Net Acquisition of Financial Assets + Net Investment in Tangible Assets -Net of Consumer Durables – Increase in Liabilities + Net Capital Transfers Paid (Flow of Fund Account of Federal Reserve Board)

None of the significant amounts of outstanding equity compensation securities owned by employees are computed within the FOF. Accordingly, we strongly believe that neither NIPA nor FOF formulas are adequate to explain the accurate value of national personal saving rates. In order to determine a more accurate value of the personal saving rate, we start our computation with the method called FOF rather than the NIPA method. Naturally, the FOF formula includes the wealth effect of acquisition of financial assets and residential investments as a part of personal saving. Thus, it is obvious that FOF provides a more meaningful and detailed explanation to estimate a more accurate personal savings rate.

Table 1 The sample data - US Compensation

Table 1 - The Sample Data

To prove our argument, we conducted research to estimate the total value of national outstanding equity-based compensation for three years, which was determined by examining company annual filings. 2, 12 During our research and study, we recognize that there is a significant relationship between the sector in which the company operates and the total value of equity-based compensation. In order to estimate the S&P 500 total value, we created a sample of 24 companies in 9 different sectors and then multiplied the sample parameters by an appropriate coefficient. (Detailed information can be found on Chart 2 regarding the companies and their sectoral divisions). For further statistical analysis, we use the fact sheet of Standard and Poor’s which reveals that  the total market capitalization of the S&P 500 companies forms 75% of the total U.S. equity market.

CHART2 Sectoral divisions of S&P500 - US Compensation

CHART2 Sectoral divisions of S&P500

As an example, the Consumer-Discretionary Sector consists of three companies—McDonald’s, the Walt Disney Companies, and Home Depot —for a total of $181 billion of market capitalization. We are confident that this sample reflects very accurate and representative data for all S&P 500 companies as the sample and S&P 500 sectoral ratios are very closely correlated (Table 1-Chart2).  [A bigger sample can be created, however some of the required information is only available in footnotes in some specific tables of 10-K annual filings and it is very limited for smaller-sized companies. We suggest that the following results can be tested for accuracy by changing the companies without changing the size and the ratios of the sample.]

In addition to this information, the outstanding equity compensation includes several iterations of equity plans which the companies provide to their employees, and the values of these equities are based on intrinsic-value calculation formulas where the stock price at the report date is used for employee stock option and stock unit valuation.3

Table 2 demonstrates our conclusive calculation that U.S. employees carry $300 billion, $540 billion and $420 billion in outstanding before-tax total equity compensation as of 2006, 2007 and 2008 respectively. The effect of these results on the actual personal savings rate is formidable.  In 2007, the recognized total value of unrealized capital gains and granted equity compensation was $240 billion; in 2008, this number tumbled to minus $80 billion. The most telling data reveal that, besides their savings, U.S. households earned unrealized $240 billion before-tax gains in 2007 from their outstanding or newly granted equity compensation plans. It is important to recall that our calculation is based on intrinsic values of equities; however, these equities have long-term contractual life (at an average of 10 years) 3 which carries even higher fair market value and represent materially greater compensation value to employees. Yet, this form of compensation is only being realized and taxed when it is exercised.

Chart 3 – Net Personal Saving and the Estimated Total Equity Compensation-Billions of U.S. Dollars

Chart 3 – Net Personal Saving and the Estimated Total Equity Compensation-Billions of U.S. Dollars

If the estimated capital gains from equity compensations are added to our calculation (FOF), the national personal saving rate rises from 4.9% to 7.1% in 2007. This study proves that existing personal saving calculations ignore a very big compensation sector, and in so doing they yield inaccurate results. Moreover, the total real saving ratio does not change significantly even in such an era of financial breakdown (Table 2). It only changes its form from cash to equity or equity to cash depending on how employees are compensated and how this compensation method affects their consumption behavior. [This study may be conducted for other recent years in order to see the trend of equity type of compensation. However, we are confident that the result will largely be the same as we know that U.S. households behave in a rational way and the companies have consistently been compensating and motivating their employees with equity awards.]

REFERENCES

1. Board of Governors of the Federal Reserve System, Washington D.C. 20551(2010, March) .   “Flow of Funds Accounts of the United States” Annual Flows and Outstandings.

2. “Company Filings“. http://www.sec.gov/edgar/searchedgar/companysearch.html.

3. Mark Lang.” Employee Stock Option and Equity Valuation”  Research Foundation of CFA Institute.

4. F. Thomas Juster, Joseph P. Lupton, James P. Smith, and Frank Stafford (2004, April). “The Decline In Household Saving And The Wealth Effect.”

5. “Fact Sheet.” http://www.standardandpoors.com.

6. Garner C. Alan. “Should the decline in the Personal Saving Rate be a cause of concern?”

7. Hakkio, Craig S., and Elisha J. Wiseman. 2006. “Social Security and Medicare: The Impending Fiscal Challenge,” Rederal Reserve Bank of Kansas City.  Economic Review First Quarter.

8. Mihir A. Desai.C. Fritz Foley. James H. Hinez.(2005, January).Foreign Direct Investment and the Domestic Capital Stock.”

9.National Economic Trends(2006, May). “Cross-Country Personal Saving Rates.”  Federal Reserve Bank of ST. Louis.

10.”S&P 500 Sectoral Ratios.” http://www.sectorspdr.com.

11. Todd S. Synder (2003).” Employee Stock Ownership Plans (ESOPs): Legislative History. Congressional Research Service reports and issue briefs.”

12. Zvi Bodie, Jonathan Treussard, and Paul Willen.( 2007, May).” The Theory of Life‐Cycle Saving and Investing.”

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