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Financial Insights

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Stepping Over the "Wealth Threshold"

21 January, 2014

By various statistical measures, financial inequality among Americans is increasing. In short, research indicates rich Americans are getting richer, while the poor and middle class Americans are losing ground. Since the recession, rising economic tides are not floating all boats.

On a macro level, the apparently increasing divergence between rich and poor prompts many questions. Does greater financial inequality help or harm the broader economy? Does it change the political and cultural dynamics of our society? What are the demographic or behavioral factors that impact financial inequality? Should the government attempt to change this trend through regulations or policy initiatives?

 

On a personal level, the questions are much simpler:

-         Financially, am I where I want to be?

-         If yes, how do I stay there?

-         If no, how do I get there?

 

Defining “Wealthy” in the United States

 

There’s an old saying that the wealthy are people who earn or own more than you. From a personal perspective, this may be true; our definition of wealth is relative to our standard of comparison. (As CNBC reporter Robert Frank writes in an August 27, 2012, commentary, “I often hear from older millionaires in Palm Beach or Carmel who insist that $8 million is not ‘rich’ where they live.”) Setting aside subjective standards, here are some metrics for the definition and distribution of wealth in theUnited States.

Annual Income

 

One of the ways to measure wealth is by annual income. The Internal Revenue Service provides annual income reports based on individual tax returns. Usually the figure used is Adjusted Gross Income (AGI). The most recent data comes from 2010 returns and shows the following:

Median household income was $34,338. This means half of all Americans in 2010 had more than $34,388 in AGI and half had less. Those above the median threshold are considered in the “top 50% of all earners,” and this group comprised 67.5 million households. The table below (using IRS data in a December 2012 Kiplinger’s worksheet) shows the AGI threshold for each level of earners:

 

       

To Be in the...

      

Your 2010 AGI must be at least...

      

Number of households

Top 50%   $34,388   67.5 million
Top 25%   $69,126   33.8 million
Top 10%   $116,623   13.5 million
Top 5 %   $161,579   6.8 million
Top 1%   $343,926   1.4 million

 

In most assessments, the top 1 percent of all earners qualify for designation as “wealthy.” Given the likelihood that adjusted incomes have increased a bit since 2010, it is reasonable to assert that any household with an adjusted gross income over $400,000 can be considered wealthy. (Coincidentally, the recent increase in marginal income tax rates to 39.6% from 35% affects single filers with AGIs in excess of $400,000, with a threshold of $450,000 for joint filers).

Net Worth

 

Some assessments of wealth argue that annual income isn’t the only relevant factor; net worth is just as important. Net worth calculates the value of a household’s financial assets (including personal residence) minus its liabilities. Using information for 2010, a January 17, 2012, New York Times article calculated the following parameters:

 

To Be in the...

      

Your net worth must be at least...

Top 50%   $121,000
Top 1%   $8,400,000

      

Using the 2010 numbers, the threshold for being in the top 1 percent is roughly 10 times greater than the median AGI. With slightly different data, the NYT article put the difference at 7.5 times. Whether this 7- or 10-fold difference between the top 1 percent and the median is too high is debatable. Of greater concern are numbers that show the gap is getting larger. A September 28, 2012, National Journal article reproduced this chart from the Congressional Budget Office:     

 

     

The three-decade trend is clear: The magnitude of the gap between the annual income of the top 1 percent and everyone else has increased dramatically. And the effect of this gap would appear to be cumulative. For, while the difference in annual income is only 10 times ($340,000 v $34,000), the difference in net worth is 69 times ($8.4 million v $121,000). According to economist Joseph Stiglitz, the author of The Price of Inequality, this multiplied difference in net worth is because “the rich save – that is, invest – 15% to 25% of their income…whereas those on the lower rungs consume most or all of their income and save little or nothing.” And thus, the rich get richer, to the point where some observers are worried that theU.S. middle class will disappear, and the population will bifurcate into two extremes: a small, wealthy, ruling class, and a large, dependent underclass.

 

Is the Wealth Gap an employment problem or a strategy problem?

 

The roots of the widening wealth gap in the United States reach back to the 1970s, when technology and global competition forced American corporations to reshape their workforces in order to remain competitive. As a result, many middle-class jobs have either migrated overseas or been replaced by automation. Gone are the days of single wage-earner families, lifetime employment, and pensions. In real numbers, incomes have been declining since the 1990s, while the costs of wealth-building essentials, particularly higher education and good health, have increased at rates greater than inflation. It’s become harder to make a living, and harder to save for the future.

One response to these economic pressures has been the proliferation of debt by individuals, corporations, and governments. As Jonathan Rauch explains in a September 28,

2012, National Journal article:

In a democracy, politicians and the public are unlikely to accept depressed spending power if they can help it. They can try to compensate by easing credit standards, effectively encouraging the non-rich to sustain purchasing power by borrowing. They might, for example, create policies allowing banks to write flimsy home mortgages and encouraging consumers to seek them. Call this the “let them eat credit” strategy.

In a booming economy, additional debt can accelerate growth. However, debt has a different effect when an economy is stagnant or declining. At first, easy credit may maintain economic growth, and allow individuals to  improve their standard of living. But eventually, lower incomes and minimal savings lead to a contraction. People – and governments – can’t pay their debts. The consequences are unemployment, fore-closures, higher taxes, fewer benefits. To varying degrees, this is where Europe, Japan, and the United States currently find themselves.

Long-term, many economists believe there will be a “re-equilibration” of income, debt, and even a narrowing of the wealth gap. Technology and the opportunity for profit will create new industries and employment. Already, many consumers are “de-leveraging” by paying off credit card balances, and forgoing further borrowing. If a higher-employed, lower-debtAmericatakes the next step, and gets serious about saving, there’s reason to believe the wealth gap will shrink as well. Here’s why:

Although we tend to see banks and brokerage houses as lenders and financiers, the real source of funds for lending is the savings and investments of other individuals – particularly from the 1 percent. When people have greater capital needs, or there is a lack of funds available, those with money to lend or invest (again, the 1 percent) stand to make higher profits. As more people build savings and proportionally reduce their indebtedness, then the dynamic changes; there is more capital available, and the profits are spread amongst a larger pool of depositors and investors. In addition, increased saving and reduced debt almost always trigger increased spending, which causes the economy to expand – without the looming threat of a debt-induced collapse. 

Individual Applications

 

Because rebalancing usually requires some short-term financial contraction (less spending, more saving), both individuals and politicians are less-than-eager to commit to the process. The typical response is to see if a little more debt might stimulate another round of growth. History shows this is wishful thinking. You can’t do much about public policy, but don’t allow this thinking to influence your personal financial decisions.

The answers to the original trio of questions about your personal financial circumstances involve some combination of income and savings. If you aren’t in the top 25%, determining how to increase income may be a critical issue. Regarding income, the NYT article on the wealthy provided an interesting statistic: The wealthiest 1 percent accounted for 36% of all self-employed income. Depending on your skill set and current circumstances, you may want to consider becoming your own boss - maybe not today - but sometime in the future.

And whether the goal is to maintain your current level of wealth or move up, maximizing saving is an essential ingredient. Referring to Steglitz’s earlier comments, saving 15% to 25% of income is a benchmark for crossing the threshold and becoming a 10-, 5- or 1-percenter when it comes to net worth. Even if your prospects for higher income appear limited, increased and consistent saving can keep you from living on the wrong side of the wealth gap.

Managing debt goes hand-in-glove with increased saving. In the short term, refinancing may help cash flow, but simply shifting debt to another bank or another credit card without eventually retiring it is not productive.

Further, well-considered saving and debt reduction strategies can be catalysts for increased income. For example, a larger down payment/smaller mortgage might result in positive cash flow from a rental property. Depending on their placement in a portfolio, dividends may be received instead of reinvested (i.e., in an integrated financial program, the saving possibilities will likely be broader than maximum contributions to a retirement plan.)

Recent public policies have not narrowed the wealth gap. Personal action remains your best strategy for crossing wealth thresholds.

 

·   If you are already a 1-percenter, stay ahead of the contraction curve through ongoing saving.

·   If you want to cross higher wealth thresholds, start or step up your saving.

·   If you aren’t sure how to move forward, seek expert assistance!