Wealth Inequality in America is Partly Due to Simple Math and the Savings Rate.

I am always amazed at when I see certain authors or publications toss around the phrase “Wealth Inequality in America” to create social unrest. The articles mainly try to make people feel how ‘unfair’ the United States is and how they cater to the rich simply by looking at a graph of how the wealthy have gotten wealthier.  I read a great research paper put out by the National Bureau of Economic Research in October of 2014 titled, “Wealth Inequality in the United States Since 1913: Evidence from Capitalized Income Tax Data”.  In that paper, they state:

“The rise of wealth inequality is almost entirely due to the rise of the top 0.1% wealth share, from 7% in 1979 to 22% in 2012 – a level as high as in 1929.”

First off, I find it interesting that the wealth share was at this level in 1929, so this is not a new phenomenon. Second, I think this can be taken many ways.  Some people would point to this factoid and claim how unfair that is and how money should be taken from the top 0.1% and redistributed through taxation.  Some people would say this is an example of how corrupt our political system is and we need a revolutionary “Robin Hood” to steal from the rich and give to the poor.  And then there is me…  I got out a calculator and punched some numbers and said to myself, “Sounds about right.”  By no means am I about to claim that everything is wonderful in the US and wealth inequality is not an issue, but I am going to present a different spin on it.

Let’s take a hypothetical rich person in 1979 and a hypothetical middle class person in 1979. The rich person was 30 years old and had $5,000,000 in investment accounts because they hypothetically created a good invention and created a company and got rich.  The 30 year old middle class person worked hard, supported a family, and saved what they could, which was currently $10,000.   Both of these people realized the importance of saving for the future and made smart decisions to invest their money.  The rich person did not need his money to grow very much, so he invested conservatively and earned an average of 5% per year on his money.  Hypothetically, the rich person also decided to retire and not add any more to his savings.  The middle class person worked hard and continued to save $2,000 per year into their savings, which was a struggle to do.  If we look at the ‘equality’ between these two hypothetical people, the rich person has control of 99.8% of wealth.  The middle class person controls just 0.2%.

Let’s fast forward now to 2012. The rich person has earned an average of 5% per year on $5,000,000 for 33 years (2012-1979).  In 2012, his investment account is now worth$25,015,942.71.  That is a dollar gain of roughly $20,000,000 over the 33 years.  The middle class person invested aggressively and did well and earned an average of 8% per year for the 33 years.  The middle class investment account is now worth $418,661.74, which is a dollar gain of $342,661.74.  So we have a 33 year gain of roughly $20,000,000 versus $342,661.74.  Based on that dollar gain, you might think or feel, ” How unfair!  The rich person has so much more money and didn’t have to work!”  However, if we look at ‘equality’, there is something surprising…  The rich person now controls 98.35% of the wealth and the middle class person controls 1.65%.  So the ‘equality’ gap has actually shrunk!  So why doesn’t this happen in real life?  In my opinion, because people in the US are horrible savers.  The current “US Personal Saving Rate Historical Data” from the Federal Reserve Bank of St. Louis shows the current savings rate of 5% of income from June 30, 2015.  I tell my clients that if they want to be financially independent then they have to save at least 20% of their income.  So if Americans aren’t saving and investing, then this gap grows wider.  If they are saving and investing, then this gap should hypothetically shrink over time.  How we solve this is up for debate and I don’ t have the answer.

However, I do know that if you start with a bigger pot of money, then the compound interest it earns is going to cause the dollar amount to grow faster than a smaller pot of money.  So much so, that the smaller pot will need years upon years of higher returns to even hope to catch up.  I wouldn’t call this ‘evil’ or ‘political corruption’ or that we need a Robin Hood to steal this money and give to the poor.  It is just simple math.

Now we add to this that the middle class person will most likely use up their savings during their retirement years and leave little or nothing to their children, who will then have to start over. The rich person will mostly likely pass wealth on and their pot of money will continue to grow.  Hence, another reason for the ongoing and increasing wealth inequality in the US.

I hope I challenged your thinking about wealth inequality. In my simple mind, it is just math.  It is just the math of compound interest and a poor savings rate.  Nothing evil or ill intentioned.  If you personally feel that the top 0.1% of wealth should be redistributed, then that is your right and your choice.  However, I ask that you now consider the big role that simple math has played in the rise of wealth inequality in the US today.  Also, if the stock market were to collapse, then this gap would shrink (as it did during the Great Depression).