Ibbotson Was Right—but Retained Earnings Explain Why

In July, I asked what happens when we look beneath the familiar story of stocks, money and compounding. That earlier RainbowStats essay, “S&P 500, M2, and Retained Corporate Capital,” focused attention on a source of equity wealth that is easy to overlook: corporations routinely retain part of the shareholders’ earnings and place those funds back into the business.

The familiar Ibbotson Stocks, Bonds, Bills and Inflation presentation is right to count the resulting appreciation as part of shareholder return. A retained dollar does not cease to belong economically to the shareholder merely because it never passes through the shareholder’s bank account. It is capital reinvested inside the corporation.

Both paths can increase shareholder wealth. Excluding the second path from ordinary equity returns would therefore be wrong. But we can still ask a more demanding question: How much value did corporations create after we charge them for the earnings they retained?

Two valid questions, not one corrected chart

The blue line below is an aggregate equity return above a modeled 10-year Treasury return. The orange line makes one additional deduction: undistributed corporate profits, treated as new shareholder capital committed to the corporate sector.

The first calculation measures what equity holders collectively received through dividends and market appreciation after adjusting for share issuance and repurchases. The second resembles an economic-profit calculation: it asks what remained after charging corporations for internally supplied equity capital.

The distance between the lines is not an “Ibbotson error.” It is the mechanical effect of charging retained corporate capital against the conventional return under our accounting counterfactual. The size of that accounting charge has varied considerably over time.

Retained earnings do not invalidate long-run stock returns. They reveal one of the institutional mechanisms that made those returns possible.

How the FRED reconstruction works

The calculation uses the Federal Reserve’s estimate of aggregate corporate-equity liabilities as the market-value measure. Transactions in corporate-equity liabilities represent net issuance; subtracting them prevents newly issued shares from masquerading as investment performance and treats net repurchases as a distribution to shareholders.

BEA after-tax corporate profits are divided between distributed and undistributed profits. We estimate dividends as after-tax profits minus undistributed profits. Because the flow series are reported at seasonally adjusted annual rates, the script divides them by four before comparing them with the quarterly market-value level. RainbowStats normalizes the published millions-versus-billions scales during arithmetic.

The Treasury comparison is necessarily approximate. It uses the 10-year yield with a duration-and-convexity estimate rather than the return on a continuously maintained investable bond portfolio. The purpose is comparison, not replication of the proprietary Ibbotson series.

The political rules have changed before

Corporate retention is not merely an accounting custom. Its attractiveness depends on law. The United States demonstrated this dramatically with the Undistributed Profits Tax of 1936. The new surtax applied graduated rates reaching 27 percent to earnings corporations did not distribute. It was intended in part to push profits out as taxable dividends and sharply increased the price of internal corporate finance.

The experiment was short-lived. The Revenue Act of 1938 essentially removed the broad undistributed-profits surtax, although the accumulated-earnings tax continued to address profits retained for the purpose of avoiding shareholder-level tax. Research on the 1936–1938 episode finds that corporate payout behavior responded to the tax and that managers also searched for other ways to preserve internal funds.

Such a change would not retroactively make the historical Ibbotson result wrong. It could, however, change the mechanism that generates future equity returns. A tax that discourages retention might increase dividends while reducing internally financed investment. A policy that favors retention might do the reverse. Either way, payout policy, capital formation and market valuation would adjust together.

The conclusion

The great long-run advantage of equities over bonds is not a statistical illusion. Shareholders supplied capital not only when they purchased newly issued shares, but also whenever corporations retained earnings that could otherwise have been distributed. When those retained funds produced future profits, the gains properly appeared in shareholder returns.

Our adjusted series asks corporations to clear a higher bar. It separates the return received by shareholders from the value created after charging management for the shareholders’ money left inside the firm. That is not a replacement for Ibbotson. It is a second lens—and one that makes the institutional foundations of long-run compounding easier to see.

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Sources and further reading

• RainbowStats: “S&P 500, M2, and Retained Corporate Capital”
• Federal Reserve Z.1: Corporate equities; liability, level
• Federal Reserve Z.1: Corporate equities; liability, transactions
• BEA: After-tax corporate profits with IVA and CCAdj
• BEA: Undistributed corporate profits with IVA and CCAdj
• Hubbard and Reiss: “Corporate Payouts and the Tax Price of Corporate Retentions”
• Congressional Research Service: “The Taxation of Dividends: Background and Overview”

Methodological note: This is an aggregate historical reconstruction, not an investable index and not a causal estimate of the return to retained earnings. Market-value changes can include revaluations and other adjustments. The constant-duration Treasury approximation differs from a realized bond-index return. FRED series are subject to revision.