Thursday, March 27, 2014

The Insights of the New Inequality Reports Relevant to Personal Finance

Those of you who have skimmed my bio will have noted that a good while ago I wrote a (unpublished) book on personal finance.  In the book, I came to certain counterintuitive conclusions about the best way to manage your money; in the last few years, I have conjectured that my take on personal finance can be used to analyze wealth management and investment patterns at the macro level, i.e., at the country or global level.  However, up to now, the only evidence I had for the correctness of my views was anecdotal.
In recent publications, the acknowledged experts on income inequality – Piketty and Saez – turn their attention (and that of their co-authors) – to wealth.  In the process, they derive some insights which place on a solid statistical foundation most of my conjectures.  In this post, I summarize some of the insights of the reports that may seem counter-intuitive to many readers, but together form a picture that places wealth – not income – squarely at the forefront of personal finance and many aspects of today’s economics.
In no particular order, here are the insights, in grossly generalized form:
1.        Over the last 200 years, except for a period around the Great Depression, “capital” (really, stocks and bonds) has consistently performed better in terms of growth of wealth than income from “labor” (ranging from salaries to CEO “incentive pay”).

2.       As a result, again consistently, there is a line somewhere around $2-$4 million in invested (stocks and bonds, not real estate or venture capital-type investments) wealth below which the wealth of the individual does not grow significantly over time, and above which his or her wealth grows at about a 7% (in real terms) rate per year.

3.       Again consistently, 50% of the population has zero or negative wealth, 40% has minimal investment wealth, and for 8-9% much of the investment wealth comes from a pension or 401(k) whose yield income is typically less than that person’s labor income.  Only the top 1-2 percent have investment income greater than labor income.

4.       The very rich (top 1-0.1%, $20 million to $100 million in wealth, plus the top 0.1%, $100 million and above in wealth) are no better investors than the other 99% (actually, the other 49%, since 50% have zero or negative wealth) – despite sometimes having certain advantages in the treatment of capital income, and in connections to investment “opportunities”.  

5.       It appears that high estate taxes, fairly high income-tax rates, fairly high capital-gains rates, and fairly high dividend-taxation rates have had little effect on this “shift to capital income”, while the main reversal of trend (the Great Depression) may have occurred because the loss of stock value was so severe (perhaps 70% from peak to trough) that many of the 1% found themselves below $2-4 million in invested wealth, with habits of high spending that were difficult to break.  Also, the Great Depression effect may have lasted for 40-odd years because high marginal income tax rates and smaller markets and pay norms did not prevent those with more than $4 million from growing at 7% per year, but did prevent most would-be entrants (typically CEOs) from reaching the magic level over the course of a career.  Reductions in tax rates, globalization of markets that allowed more scope for high CEO salaries, and new norms of compensation that piled direct-to-investment stock options on top of large increases in salaries in the 1979-1990 time period probably broke the Great Depression mold.
Here are the initial conclusions I draw – or, more properly, move from “anecdotal evidence” to “firmly based in statistics”:

1.        The aim of personal finance should be to achieve $2-3 million in low-expense-ratio S&P 500 (or Russell 2000) index funds.   Note that Vanguard typically has a 0.1-0.2% expense ratio over time.  The tendency of the rich to invest instead in high-expense-ratio actively-managed funds, in bonds, in derivatives, in hedge funds, in real estate, in venture capital firms (assuming that the aim isn’t philanthropic), in listening to con men, in conspicuous consumption, and in political maneuvering to protect labor income from miniscule threats, explains why the average rich person is no better at investing than the less-well-off 401(k) owner who is forced to deal with lack of available index funds and 2% fees in the 401(k), as well as less opportunity to use capital-gains, dividend, and interest tax advantages.

2.       Overall, these wrong investing decisions cost the top 50% about 1.5% per year (based on a study that showed that in real terms, a Vanguard S&P 500 index fund or the like grows about 8.5% per year).  They also suggest that unless there is less than 15 years to go until retirement or one’s employer is also contributing significantly, investing directly in such an index fund may be better than putting that money in a high-expense-ratio 401(k) or IRA.

3.       It also follows that once one reaches the “safe rich” category as defined above, there is far less urgency about piling up more and more than is assumed.  What the rich buy in terms of power to protect their money with the extra cash is unneeded in the first place.  Economics, as many have said, is not a morality play; but if one reaches the “safe rich” category, it is perfectly reasonable to do the moral thing and not stretch desperately after more and more and more, and the person who does so will typically not suffer any real penalty.

4.       The first macro implication of these insights is that income tax and estate tax tweaking is strictly limited in its effect on this “investment rich get richer” trend.  It now appears unlikely that we can reverse the trend by limiting entry into the “$4 million and up” investment club – although we can prevent its spread to many of today’s CEO wannabes.  No, by far the most powerful tactic for preventing rapid wealth/income rich-share expansion (and, by the way, the top 1% now have 40% of the wealth and the top 0.1% 20-22% of it) is an investment-wealth tax.  France, I note, has a general-wealth tax of 2%, which has helped somewhat – one might consider putting it at 3.5%, to counter the effects of 2.5% inflation.  Note that this will simply take the rich’s yield down to 3.5%, still enough to ensure some wealth increase, but one-half the increase of the 49%.  I limit it to investment wealth, because the data suggest that if the super-rich shift to other forms of investment, not only will their own income suffer (stock options), but their own investment yields as well.  However, other distortionary economic effects may mean that one should echo France.

5.       The second macro implication, I believe, is that inequality and its follow-on economic effects is not primarily a problem of income inequality, or as Krugman conjectures in recent blog posts, a matter of inherited wealth – the Rockefellers and Vanderbilts are still doing quite well through stringent estate taxes and loosened ones.  It is, rather, a matter of regulating both entry into the “safe wealthy” category and the amount of wealth growth once one has reached that stage.  To have a hope of long-term success, in other words, inequality policy must deal with investment wealth above a certain level.

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