Who is rich?

Presidential candidates Obama and McCain have a little trouble defining who is rich in this country. I’m going to do a little arithmetic here to help them out. (OK, so I admit they don't need my help; they have more than sufficient resources available to do this. I'm doing it to get a handle on this for myself, and am sharing the results).

I think this can be defined a few different ways. For example, in terms of annual salary, or in terms of net worth, or both. I am suggesting one method of determining “who is rich”. Using the simplified method which I detail below, a median male worker who saves a significant portion of his earnings (wages) over his entire working life and prudently invests these savings, can achieve a “nest egg” of about $1.6 million dollars at a retirement age of 66. Any one who achieves more, could be construed to be “richer” and someone who achieves less could be called “poorer”. However, this simplification does not take into account numerous choices that the "median male" might make along the way, and which could impact the result. Other factors, including health, work ethic, education, spending and saving habits, etc. could all play a part. The assumption uses a savings rate, and it is certainly possible not to save at all during one’s lifetime. In fact, with the widespread availability of credit over the past few decades, many individuals have spent more than they can earn and have effectively mortgaged their future. Such is the American Way. However, while this may be true for some Americans, it does not justify what they have done, nor would it be appropriate to penalize those who made other choices such as saving. However, our government does levy a penalty upon savers.

Be that as it may, I am making a political assumption that the issue of who is rich and who is not, is being promoted by the presidential candidates as a question about who to punish with additional taxes and who to spare.

In terms of net worth, who is “rich”? That’s an interesting question. Rich would imply better off in a financial sense than most of us. So is it possible to determine who is “better off”? I think it is possible to make some generalities.

We do know what the median income is for men in this country. Women make less. But let’s use the figure for full time working men as the basis for this inquiry. According to the US Census Bureau, in 2007 this was $45,113. If someone were able to work a lifetime and save a significant portion of each year’s earnings, invest it and achieve a modest return, they would accumulate a certain amount of wealth. My question is, how much could a “median man” accumulate? In a lifetime, I would expect that would determine the wealth of this “median man”. That would be his net worth, and anyone who achieved greater wealth than that could be defined to be “richer”.

In this example, we would have to make some assumptions. These include long term inflation and annual return on the amount saved. We would also have to make an assumption about how much this working “median man” could save each year.

So here are my assumptions.

Initial annual earnings (wages) = $45,113
Annual wage increase = 1.8%
Long term rate of inflation = 4.5%
Long term rate of return on investments = 7%
Number of years in the work force = 45
Value of Company Pension Plan = $0
Value of Social Security = $0
Value of Civil Retirement = Value of Social Security

How did I arrive at the above percentages? According to the census bureau, annual wages over long periods of time increase only slightly over inflation. I used per capita income for white males from the US census bureau as the basis, for the period 1967 to 2007. Income increased at a rate of 1.8% per year over this 40 year period. I used this value to represent that annual increase in income. Now in real life, people often start at a lower wage and as their skill and value to their employer increases, so do their wages. But not at a smooth or low annual rate. So in real life, wages sometimes increase in steps from time to time. So using the median wage value over someone’s entire life is a simplification.

Long term inflation in the past is a well known number. However, long term inflation over one’s entire working life is more difficult. I used 4.5% which is based on the CPI since 1963.

Long term rate of return has been linked to several factors. I will base it on the stock market returns that can be expected. These returns have been shown to includes real GDP growth, inflation and dividend yield. The result is a return in the range of 7 to 8%.

How much can someone save over their lifetime? That is more difficult to predict. Many financial planners and advisers recommend 10% of one’s earnings. That would be difficult for many of us to achieve, and this is certainly far more than the average or median American saves. However, if we assume these savings include one’s home and certain retirement savings, then it is more readily achievable.

How many years will one save? Let’s assume one enters the workforce at the age of 20. That allows time for high school plus trade school, apprenticeship or college. Let’s also assume that one works until their 66th birthday. In fact, many people had been retiring earlier but due to longevity and other factors, current data indicates that this trend is changing and that more people are choosing to work beyond their 65th birthday.

The value of a pension plan should also be considered. According to financial data, businesses are abandoning traditional pension plans for 401K and similar plans. Some of these plans permit employee contributions and some do not. Some plans (such as for teachers and other civil servants) in certain states, replace social security for the wage earner. For those workers, it would be proper to compare their pensions to the social security benefits of the private sector. Both of these additional plans have problems. Some states are not adequately funding pension plans, and so there is no guarantee these funds will be available at retirement. For it’s part, the federal government has spent the social security surpluses, and so the private worker also cannot assume the funds will be there in retirement. This is especially true for younger workers. So to simplify this, I have ignored social security and I have also ignored similar pension plans in the civil service sector. However, 401K or 403B and other plans over and above such government pensions or social security should be included when determining the net worth of an individual. So that money that your employer is socking away in your name plus matching funds you are putting into your 401K should be included when making any analysis. On that basis, the 10% savings rate is not as ridiculous as it might at first seem to be.

Putting all that together into a spreadsheet yields a view of the net worth of someone who begins working at the age of 20, and saves 10% of those wages each and every year until the age of 66. That same individual achieves a wage increase of 1.8% each and every year, so the amount saved also increases every year, but remains at 10% of the wages. Each year the saved “nest egg” increases in value by 7%. So what does that give us?

In year 1 (age 20 to 21st birthday) $45,113 in wages are achieved. 10% of that is put into an account. So $4,511.30 is saved. At the end of one year, this has appreciated at 7% so the amount saved is now $4,827.09. 10% of the wages earned in that year are then added to the amount saved. However, wages increased by 2% and so did the amount saved. This goes on year after year, and each year the amount invested increases in value at 7% and 10% of the wages earned in that year are added to the savings amount.

Using this approach, after 10 years of working and saving, this person would have accumulated $66,962.35 in savings. After 20 years, this amount would be $211,765.34. After 30 years, the amount saved would have reached $512,246.79. After 40 years it would be 1,122,024.31. Finally, at retirement, this “saver” would have accumulated $1,628,464.68.

Now this amount could include the saver’s house, if part of the annual savings was put toward a home. However, that decision poses some problems, the simplest of which is the appreciation rate of housing. Homes generally do not appreciate at a compounded rate of 7%.

However, that said, I think the numbers imply it would be difficult for a median worker to achieve a net worth of more than $1.6 million dollars over one’s working lifetime. I have simplified the math and I have also assumed no pension plan, no social security or similar retirement plan. So the results do not really provide a true net worth value for the “median” income man, who could and probably will have some social security income or civil pension. A more thorough comparison would take these into account. If one had an "old style" company pension, then that should be compared to the value of an annuity and added to the net worth. This simplification also does not take into account the possible income and resulting savings of a couple who both work and therefore earn higher sums.

I apologize to the ladies. I used the figures for a median male. This was deliberate only because I wanted to use the higher number. The median wage for a woman is less, according to the census bureau.

Another thing to consider is the impact of inflation on the accumulated nest egg. As time goes by, the purchasing power of the dollar has declined. I have not included an analysis of that erosion. In simplest terms, by the time the "median man" retires, that nest egg will have lost significant purchasing power and will be worth far less than is implied.

In closing, this also puts some perspective on the earnings of very high wage earners. Entertainers, sports celebrities, the privileged few which includes some of the CEOs and officers of corporations, politicians, professionals such as lawyers and medical practitioners. They are “rich” if they have accumulated a net worth many times greater than that achieved by the median income worker in this example. However, many of these people also choose to flush inordinate sums of money each year, and in so doing, achieve a lower net worth at retirement than that possible for the median wage earner used in this example.

Let me also state that I am not a lawyer, an accountant or a politician. So this example is not about presenting a case or brief. It is not about who is to be taxed and who is not to be taxed. It is about presenting a simplified method of framing what is meant by and who is indeed “rich” from the perspective of accumulated wealth. There are those who would argue that it isn’t possible to live in retirement on a nest egg of the magnitude I presented here. However, I pose that says more about them than about me. According to data from the US Census Bureau, net worth for married households age 65 or greater is $201,667 and for those the ages 55 to 64 it is $195,196. So from that perspective, our saving “median man” is very rich indeed. Or perhaps we should look at it the other way. It is possible the average married household the age 55 and above is poor and ill prepared for retirement.