At first blush, David Splinter’s excellent doctoral dissertation about income variability and its effects on inequality seems to have little to do with financial planning for top one percent earners. I acknowledge that.
However, Splinter’s research provides some superb insights for entrepreneurs and other high income earners struggling to develop smart financial planning strategies.
This week’s post, therefore, summarizes some of Splinter’s fascinating findings. And then it tries to tease out three truly useful insights related to financial planning for top one percent entrepreneurs and small business owners.
Let me also make this important point: Even if you’re not currently a member of the top one or top five or top ten percent, keep reading. What we’re going to talk about is relevant to way more people that one might at first guess…
Splinter’s Findings & Financial Planning for Top One Percent
Dr. Splinter’s research explores an obvious but underappreciated reality: Bad luck can cause people’s incomes to fall dramatically and good luck can cause people’s income to rise dramatically, but over time incomes tend to average out.
Restated more precisely and quoting from Splinter’s Ph.D. dissertation,
…mean reversion results from negative shocks temporarily pushing families into low earnings groups and positive shocks temporarily inflating the earnings of families at the top of the distribution.
In rich detail, Splinter shows that more of this bouncing about (more of this variability) has occurred over the last few decades. He also calculates that this variability explains a lot of the growing inequality that we talk about in this country.
A bunch of interesting facts and questions drop out of Splinter’s work. But one particularly thought-provoking insight stands out for top one-percenters. And here it is: Over time, a top one-percenter’s income may be very likely to dramatically drop.
Splinter’s research data set shows, for example, that ten years out, a top one percenter saw their income fall by about 60 percent. (If you want to verify or get more data about this statistic look at Figure 2.6 in Splinter’s dissertation and read at least pages 38-40.)
And just to make this important point, too: Splinter’s research doesn’t stand alone, crying in the wilderness. His research dovetails with what other researchers have found. Cornell University sociologist Thomas Hirschl more recently published very interesting research that concludes lots of people move into and then out of the top income percentiles.
You have about an 11% chance of joining the top one percent at some point during your working years, for example. And about a 40% chance of joining the top five percent, a 50% chance of joining the top ten percent, and about a 70% chance of joining the top twenty percent. The rub is, your (or my) membership is any of these clubs is possibly and maybe even probably only temporary.
Splinter’s Ideas Matter to Successful Entrepreneurs
Okay, the fleetingness of a high income maybe doesn’t surprise you. You probably always suspected or at least worried that this was true. But that transitory nature matters a great deal for a high income person’s financial planning.
In fact, Splinter’s research data and Hirschl’s too suggests to me three “financial planning for top one percent” ideas.
First, if you’re a financially successful entrepreneur or other high-income person, you maybe want to think about your financial success as resembling the situation a professional athletic faces. Yes, you may make very good money while you’re “playing” the game. But your income will probably drop once you “quit playing.” What you may want to consider doing, therefore, is smoothing your consumption by saving most of the windfall and prudently investing that money. (I know… “boring!”)
Second, I think the data suggests that, overwhelmingly, one-percent earners are unable to follow-up with a second one-percent income generation venture. In other words, lightning doesn’t strike twice. We would expect this for professional athletes and performers obviously. Successful NFL football players don’t go on and become successful professional golfers. Rock stars generally don’t become Oscar winning actors or actresses. (Okay, yes, Cher did.. but quick, can you come up with several additional examples?)
Clearly, the “lightning doesn’t strike twice” reality seems to apply to most one percent income situations.
Third, and finally, the one workable method for maintaining a high income is to compulsively save a large chunk of the high income. For example, if someone making $5,000,000 a year pays a 50% tax rate, saves $2,000,000 of the after-income and then spends the remaining $500,000 of income, he or she still enjoys a very high level of consumption in the non-income-windfall years. (This person by my rough calculations needs to save for seven or eight years in order to be able to sustain that $500,000-a-year consumption level.) But that’s the only theoretically robust way to maintain a high income-even if legions of successful people have proven its impracticality. (Sorry.)
Not Yourself a Member of the One Percent?
Most people reading this blog post are not members of the top one-percent, obviously. Or the top five or top ten percent. And so many people might assume they don’t need to think about “financial planning for top one percent” situations. But can I challenge that perspective?
Three other interesting take-aways appear in Dr. Splinter’s and to a certain extent in Dr. Hirschl’s work.
First, the same “averaging out” or mean reversion tendency applies to people with low incomes, too. Furthermore, low incomes tend to spike back up more quickly than high incomes crater. That’s good news. Bad times don’t last. Or they don’t have to last.
Second, a subtext of Splinter’s work is that life-time or multi-year earnings matter. And you and I ought to think the same way. A good job or a sturdy professional opportunity or even a modestly successful but still small business may produce just as good an outcome over two or three decades as a brief flash-in-the-plan deal. Especially if you and I save money into a tax-deferred retirement account, use some common-sense in our investing, and keep a check on our consumption.
Third, most people will at some point, maybe only briefly, see their incomes spike way up. What you want to do–and you’re not going to be surprised to read this–is save the entire windfall. You really will want to take all the windfall, stuff as much of it as possible into your family’s retirement accounts (maybe for more than just the current year), and then pay off your mortgage if you’ve got one.
Financial Planning for Top One Percent Resources
The Rich Get Poorer: The Myth of Dynastic Wealth
Money Mistakes of the Top One Percent
Why Early Mortgage Repayment Makes Sense for High Income Taxpayers
Index Funds and Asset Allocation Even Better for the Wealthy
Real Estate vs IRA and 401(k) Accounts. Part I
And one other resource worth peeking at: Check out the first graphic, “Showing Economic Data with Dynamic Graphs“ , at David Splinter’s website. (Be sure to click the play button.)
The way of explanations and writing is too good steve. Keep doing good work. Thank you for sharing such awesome article.