I was recently pleased to note that a Frontline program from last year (“The Retirement Gamble”) had finally begun to note the virtues of low-expense-ratio large-market-index index funds. This year, we have Piketty and Saez, who have finally noticed the importance of wealth rather than merely income in creating and maintaining the ranks of the rich. They echo what I wrote in an (unpublished) book on money management for the rest of us 15 years ago: that while over the long term (20 years or more) stocks are the best bet, there are two sets of people who will guarantee that your stock investments will under-perform: other people (most advisers and fund managers) and yourself. Index funds are on auto-pilot; they avoid both sins.
However, what I really had not thought deeply about 15 years ago was that simply putting half of your money available to invest in a reasonably diversified stock portfolio (the rest, say, in bonds), above a certain level of investment “wealth”, will effectively guarantee that you will get richer and richer relative to everyone else. In other words, unless you manage to spend so outrageously that you go below that minimum amount (despite what you think, it’s not easy), your net worth will over any 20-year period grow at such a rate, on average, that it will double every 8-15 years. $5 million today? If you go for an S&P 500 index fund from Vanguard with a 0.1% expense ratio, it will be $10 million in 2022, $20 million in 2030, and $40 million in 2038, or about when you’re ready to pack it in if you’re 60 now – and that’s after inflation.
And those who don’t invest in stocks (reasonably diversified) and are lucky enough to avoid a shark like Bernie Madoff (as the late Robin Williams remarked, “Was the name not a clue?”) – i.e., those who aren’t rich – will find it much harder to get rich, at the least. Bonds? 1-2% above inflation, often less than enough to cover living expenses. Houses? 2% above inflation at best, because all those fancy sales figures don’t show the large amount you must spend on upkeep to keep them usable. Anything else? Historically, either worse, or the equivalent of hoping to “win the lottery”.
Rich Person’s Game
So here’s how it works, for a particular rich person – one, say, starting with $3 million in the Vanguard index fund referenced above, and with a net wage income of, say, $57,000. That index fund, on average (actually, something called the geometric mean), generates about 10.85% per year before inflation, about 8.6% after. About 2.25% of this comes from dividends, or $67,500, on which you pay 15% tax, or about $10,000, leaving you with $57,000 (net return about 8.3%). Now let’s assume that you live on your income for the first year. The next year, you have about $3.25 million. What about capital gains? The S& P fund is superb for avoiding most of those – the smallest stocks in the index are the ones that get bought and sold (enter or leave the S&P 500). And you’re still paying only 15-20% in taxes on those.
8 years from when you start (when you’ve doubled your money), your take from your dividends has reached $114,000. However, you’re still getting a net of about 8.3% from your investment, year after year. Over time, the amount of capital gains gets slightly larger, but – here’s the shocking kicker – after you die, the “cost basis” from which capital gains get computed goes to the stocks’ current value, which means that capital gains of anything that gets sold after that goes back to about $0 again. How could Mitt Romney pay 10% of his income in taxes? 1/3 of the income was dividends, and 2/3 was sale of stocks with effectively 0% capital gains tax. I don’t know if that’s what happened, but that’s how it could be done.
The most amazing thing about this is that you can up the taxes, assume that the rich person is sub-optimally investing by a large amount, and still, the net worth will keep marching on up – by less, but still by enough to handle a lot of wasted spending. At $6 million, you can spend money on four $100,000 cars per year and your net worth will still march on upwards. At $12 million, you can afford an $800,000 second house, cash up front, and you will still be gaining. You can give away 3% to an active manager of a fund in a 401(k), and still be doing well. You could be taxed on your wage income at 90%, or your dividends and capital gains at 50%, and you’re still doing excellently, increasing your net worth more and more.
In fact, many rich people do invest poorly. They go for active funds, investment advisors, hedge funds (performs less well than index funds over time, latest figures show, and the fund is taking perhaps 80% of the profit), far too much in the way of bonds (by some figures, about 50%), and plenty of fads. Piketty’s figures seem to suggest that they’re no better than the few non-rich who have to use 401(k)s with their rigid menu of non-index funds and high fees up and down the line (estimates are it costs us 2-4 %). The difference is, the not rich are trying to reach that magic $3 million, and using some of the investments for living expenses, because they have to. Even at $500,000 in investment wealth, you’re still in real danger of getting poorer. But the rich get richer.
And the higher you go, the less job income matters. Don’t like the CEO’s $10-million-per-year package, 400 times the corporate median wage? If that CEO is a billionaire, he or she is earning $80 million a year just from investments (if it’s our index fund example), or $40 million if he or she is the typical lousy investor.
And so, what the CEO earns (most of the rich are CEOs, including CEOs of financial firms) is not a case of the rich getting richer; it’s a case of the head of the firm finding a way to enter the charmed circle of the rich, quickly. Controlling inequality is not a matter of controlling income from work; it’s primarily a matter of controlling the amount the invested rich reap from their stock investments compared to the non-rich.
Why Even the Best Don’t Seem to Fully Get It
Most commentary about today’s increasing imbalances in income and wealth seems to fall into three categories. The first category is those who justify these imbalances as somehow reflecting the value of the individual who is becoming richer and richer. Of what added value to society is an individual who simply sits on an investment and watches it grow (remember, that’s how today’s rich are increasing their wealth)? Anyone can do that. No, to me those who justify the imbalances are the equivalents of the prostitute in one of Douglas Adams’ Hitchhiker books, whose sole source of income is assuring the rich that they really do deserve all that money, and those who criticize them are just meanies.
The second class of commentators are aware that there’s a problem, but seem to think that income taxes are the solution. Rather, high income taxes slow the flow of new rich into the charmed circle, but have very little effect on those who have already joined – they get most of their money through dividends and stock appreciation.
The third set of commentators – I would include Paul Krugman and Piketty and Saez in this class – realize that there’s a problem, and that it’s connected to wealth. However, the same sophistication in economics and understanding of data collected about the aggregate within a nation that allows them to see the results of the rich getting richer right now, seems to fail them when they actually consider the connection between national trends and the individual case.
In the case of Piketty and his better critics, the question focused on is whether “r-g” will continue – at a guess, whether the rich can continue to gain a larger piece of the pie indefinitely. But that’s a question with an easy answer: as long as stock markets continue to deliver outsized returns over the long term, as they have done for at least the last 95 years, and taxes and very severe depressions do not shrink wealth to the point where many fall out of the charmed circle (as seems to have happened in the forty years during and after the Great Depression), then the rich will indeed get richer. And yet, looking at things from the perspective of national economies, the idea that the rich can have a bigger slice of the pie for a very long time seems counterintuitive. And so, the idea of higher income taxes and estate taxes is the focus, while a wealth tax such as the one in France is barely mentioned and assumed not to be an effective path to reversing wealth and hence income inequality.
To my mind, one of the main reasons for this “difficulty in getting it” is the fact that we don’t see most of the appreciation of stock in the data – it shows up only as capital gains when the stock is sold, and even those are far less than the real income appreciation. Remember, you first pay out of dividends, and then take a little capital gains when the index fund has to rebalance, and when you die the cost basis is reset and when your inheritor sells it seems as if there has been little increase in the stock. So, over 30 years your wealth may multiply by 8 times and yet, going by dividend and capital gains figures, it has not yet doubled.
There is, by the way, one really strange way that we also underestimate the wealth underlying capital gains reporting. Let us suppose that we arbitrarily decide to sell 0.8% of our stocks every year. Remember, each year the value of the stocks goes up by 8+ %, so for the first ten years, we are paying capital gains on our first year’s gain in stocks, and by the end of the 20th year, we are still paying capital gains on the second year’s gain. However, during the 20 years, we have seen inflation that has effectively reduced the value of the money we are paying. So, at about 3.5% inflation, that payment in the 20th year, in real terms, is about ½ of what it would have been if we had paid at the end of the first year. This, by the way, is another way that the rich reduce their taxes in real terms.
Now, if at the time of your death you had to sell all your stocks, all those capital gains savings on delayed capital gains tax payment would be reversed. But you don’t – you will probably have to sell relatively little of the stock. And so, the real cost of the capital gains to your heir keeps getting smaller, and smaller, and the amount of actual wealth relative to the amount of capital gains reported keeps getting larger and larger …
The Personal and Global Bottom Line
I see two take-aways from this analysis of the investment rich getting richer. The first is personal: whoever you are, if you aren’t rich by my definition, get somehow to a net worth of at least $1.5-$3 million that includes at least $1.5-$3 million in diversified stocks. Then, by the method I’ve outlined, you should be set for life. Note that this doesn’t include expenses from your support for other people, such as a spouse and children – ideally, they too at some point in their lives should reach equivalent wealth, so they are set no matter what happens to you. Yes, I realize that for most this is very hard to do, and that the kind of fees we see out there when you do a 401(k) or an actively-managed fund or get investment advice or try to do stock investing yourself make it much, much harder. All of this discussion of how to optimize your investments is in my unpublished book of 15 years ago.
My second take-away applies in the area of global economic policy. Piketty and Saez have masterfully shown how, with the exception of the period after the Great Depression, income and wealth inequality have grown steadily over at least the last 150 years. Unless policy deals with the underlying reason, as I’ve laid it out, that the rich can indeed get richer in relation to the rest of the world, then policy is very likely to be ineffective. That means serious consideration of a wealth tax such as the 2% one in France, as long as it applies to stock investments. Personally, I’d make it a 3% tax targeted at the rich – those who are smart enough to weight their investments heavily in index funds will continue to grow in wealth, but the majority, whose yield is much less, should see an almost flat net worth trend.
Of course, you still have to deal with the problem of making such a tax global, else the rich will just domicile elsewhere. Still, as with other taxes, there are ways of dealing with this to some extent. If we wish to get a handle on a problem that makes the global and US economy underperform and also has very bad effects on the non-rich, we need to target just exactly why the rich are getting richer, and target our solutions to that understanding. Here’s hoping we won’t take decades to do this.