New Study Reveals the Secrets Behind the Wealth Gap and How to Bridge It, See Inside
Not born rich? No problem, the Federal Reserve did a study on how to get rich.
Why are the wealthiest so wealthy? The economic research department at the St. Louis Federal Reserve tried to understand it for us in their 2023-004A working paper.
Source Report: https://s3.amazonaws.com/real.stlouisfed.org/wp/2023/2023-004.pdf
The report sheds light on the complex factors that contribute to wealth accumulation differences between the New Money and Old Money, and provides insights into the importance of different components such as rates of return, saving rates, and initial conditions.
The wealthiest individuals begin their lives with substantially higher wealth than others in the same cohort.
Wealth concentration declines over the lifecycle, particularly between ages 25 and 35, as the bottom half of the wealth distribution accumulates wealth at a faster pace and converges to the average wealth in the economy.
The wealthiest individuals tend to have a higher portfolio share of equity than other households in the same cohort, with numbers hovering between 85% and 90% over the past 22 years.
Future average returns are positively correlated with initial average wealth.
By age 50, higher initial wealth, saving rates, and returns on wealth account for the majority of the wealth gap.
Higher saving rates and returns on net wealth primarily account for the wealth gap between the New Money and mid-wealth households with higher labor income, while the fortunes of the Old Money are mostly due to higher starting wealth.
New Money households earn higher returns on net wealth than their Old Money counterparts.
Inherited wealth from parents has a major impact on lifetime resources.
High saving rates have a significantly larger effect on net worth at age 50 compared with higher rates of return or initial wealth.
The New Money started below the median wealth but experienced rapid wealth growth early in life, thanks to their higher saving rate and higher returns on net wealth.
An Empirical Investigation Reveals Why the Wealthiest are So Wealthy
The concentration of wealth in the hands of a few has sparked intense debate in academia and the public sphere. To gain insights into this issue, researchers Elin Halvorsen, Joachim Hubmer, Serdar Ozkan, and Sergio Salgado conducted a longitudinal study of household wealth dynamics using Norwegian administrative panel data on wealth and income. Their findings shed light on the mechanisms behind wealth concentration and offer suggestions for policy interventions.
According to the study, the wealthiest individuals begin their lives with substantially higher wealth than others in the same cohort. However, wealth concentration declines over the lifecycle, particularly between ages 25 and 35, as the bottom half of the wealth distribution accumulates wealth at a faster pace and converges to the average wealth in the economy.
The wealthiest individuals also tend to have a higher portfolio share of equity than other households in the same cohort, with numbers hovering between 85% and 90% over the past 22 years. The long-term average annual return on net wealth increases from approximately 1.5% for the bottom 50% of the wealth distribution to around 10% for the top 0.1%.
To simulate counterfactual wealth profiles, the researchers replaced each variable in the budget constraint with its average value for a reference group – the middle 50 households of the same age. They found that future average returns are positively correlated with initial average wealth. By age 50, higher initial wealth, saving rates, and returns on wealth account for the majority of the wealth gap.
The study also revealed that higher saving rates and returns on net wealth primarily account for the wealth gap between the New Money and mid-wealth households with higher labor income, while the fortunes of the Old Money are mostly due to higher starting wealth.
The researchers used Norwegian administrative panel data on wealth and income, which includes assets and liabilities that individuals are required to report to the tax authorities, even if they do not meet the threshold to be taxed. The data, while of high quality overall, exclude the value of private or public pensions and assets whose value is difficult to measure, such as art or jewelry.
The findings of the study show that the average wealth in the US increases from 0.15 AW to 2 AW between ages 25 and 65 and declines afterward. Median wealth grows faster than the average, indicating a steeper wealth profile in the bottom half of the distribution. Wealth concentration declines over the life cycle, with the share of total net worth held by the top 1% declining sharply. These similarities suggest that similar economic forces may be at play behind the life cycle wealth dynamics in both countries.
The study concludes that the wealth distribution is highly skewed, and the top 1% or 0.1% of the wealth range is quite wide, which can mechanically explain the persistence at the top of the wealth distribution. Rapid wealth accumulation is more common than rapid dissaving or squandering. The researchers also find a substantial degree of persistence, especially at the top of the wealth distribution.
New Money Earn Higher Returns on Net Wealth Compared to Old Money, Economist Reports
New Money households earn higher returns on net wealth than their Old Money counterparts. The difference in returns is largely driven by the fact that equity investment is riskier for the New Money, who also tend to save at higher rates than their Old Money peers. However, within the top 0.1% of wealth owners, the saving rate is declining.
The report focused on five main sources of heterogeneity, including rates of return, saving rates, initial wealth, labor income, and inheritances, including inter-vivos transfers. By quantifying the importance of these channels, the report was able to identify the factors that contribute to wealth accumulation differences between the New Money and Old Money.
To simulate the counterfactual evolution of wealth, the report started with the budget constraint in the initial year for a group of households and simulated the wealth profile for following years. For example, to investigate how the wealth profile would look for the top 0.1% of wealth owners if they had earned the same rates of return as the middle 50% of the population, the report constructed the average wealth profile for the middle 50% and weighted after-tax returns by Wi(t-1) to construct Rh(j,t) and of Si(t) weighted by total income to construct Sh(j,t).
The report found that income received between 1994 and 2014 did not significantly affect the wealth of those that reached the top 0.1% of the wealth distribution. Instead, inherited wealth from parents had a major impact on lifetime resources. High saving rates had a significantly larger effect on net worth at age 50 compared with higher rates of return or initial wealth.
The report also used the Shapley-Owen decomposition to study wealth accumulation of subgroups of the top 0.1%. It found that the Old Money relative to the P25-P75 group had little importance in explaining the fortunes of the wealthiest households. In contrast, the New Money started below the median wealth but experienced rapid wealth growth early in life, which accounted for their fast ascent to the top, thanks to their higher saving rate and higher returns on net wealth.
The data used in the report were tax returns for all persons in Norway from 1993 to 2015, and housing wealth was imputed using an ensemble machine learning method on housing transaction data for the same period. Housing wealth was allocated to individuals according to ownership shares. Norway has a dual income tax system where tax on capital is proportional and tax on labor is progressive. The report also measured private equity in tax returns as the firm assessed tax value of shares in non-listed Norwegian firms plus non-listed bonds and options.
Key Factors Contributing to the Concentration of Net Wealth in the Top 10% of Households
The top 10% of households hold the majority of the economy-wide net wealth.
Intragenerational persistence of net wealth is high, meaning that it is difficult for individuals to move up the wealth ladder during their lifetime.
Asset allocation and leverage are important factors in building and maintaining wealth.
Investment returns tend to be skewed and concentrated in the top 0.1% of the wealth distribution.
Intergenerational persistence of net wealth is also high, meaning that parental wealth is a strong predictor of a child's future wealth.
Earnings growth and education are significant factors in determining lifetime income and wealth.
Stability and consistency in financial decisions and planning can lead to long-term wealth accumulation.
Ownership of real estate is an important contributor to overall wealth.
The saving rate is a critical factor in building wealth over time.
Now You Know How to Become Wealthy
The St. Louis Federal Reserve on wealth accumulation differences between the New Money and Old Money sheds light on the complex factors that contribute to wealth concentration. The study shows that the wealthiest individuals begin their lives with substantially higher wealth than others in the same cohort, but wealth concentration declines over the lifecycle, particularly between ages 25 and 35.
The report highlights the importance of different components, such as rates of return, saving rates, and initial conditions, which account for the majority of the wealth gap. Furthermore, the study concludes that the wealth distribution is highly skewed, with a substantial degree of persistence, especially at the top of the wealth distribution.
The report also notes that New Money households earn higher returns on net wealth than their Old Money counterparts and suggests that the difference in returns is largely driven by the fact that equity investment is riskier for the New Money.
Your Friend,
Cody Krecicki
A.I. Financial Writer