Where the rich get their money

by Robert Frank

Much of the debate over taxing the wealthy focuses on taxing giant salaries.

But a new study from the nonpartisan Tax Policy Center found that the real money for the wealthy is made from investments and business income—not compensation.

The paper, from Joseph Rosenberg, takes a broader definition of income. The so-called "Expanded Cash Income" includes retirement and health-care benefits, retirement income, tax-exempt interest and other add-ons aimed at providing a more accurate picture of the nation's income distribution.

The results show a stark contrast between the 1 percent and the rest. The population as a whole earns 64 percent of its expanded cash income from so-called "compensation," basically a paycheck from a company. But the top 1 percent earns only 39 percent from compensation. It gets 24 percent from business income and 29 percent from investments.

The top 0.1 percent is even more reliant on investments, with 35 percent of their income from investments.

In other words, the richer you are, the more likely you'll make your money from investing or owning a business.

As Jared Bernstein of the Center on Budget and Policy Priorities points out, "Once you get up to the very top of the income scale ... you've got two-thirds of their income coming from nonlabor sources."

That's not to imply that the wealthy are just living off passive income, or that they're not working as hard as the everyday American. 

"When we think about small business owners, these are 24-7 people and they can be working harder than you or me," said Roberton Williams of the Tax Policy Center. He said there is little correlation between the type of income people receive and their level of work.

Indeed, economist Emmanuel Saez of the University of California at Berkeley writes that since the 1970s, the rising incomes of the wealthy are due largely to a growth in their wages and salary income.

"The evidence suggests that top income earners today are not 'rentiers' deriving their incomes from past wealth but rather the 'working rich."'

Of course, working might also mean "owning."

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Our Expert (Finally) Reveals His Personal Retirement Strategy

by Walter Updegrave

I haven't said much about my own finances in the more than 1,000 Ask the Expert columns I've written over the past 13 years. Everyone's situation is different, so I wouldn't want people to assume they should follow a particular strategy or invest in a certain way just because "The Expert" has done so.

But since I'll be leaving MONEY at the end of this month, I thought it would be appropriate to share the overall approach I've taken to retirement planning during my 26 years at MONEY in the hope that readers might apply it not in every particular, but in a general way to their own planning.

I'm not going to get into the nitty-gritty details. My wife would have my head if I started divulging account balances and such. Rather, I'll break down my retirement-planning efforts into two broad categories, specifically: What I've Done Reasonably Well and What I Could Have Done Better.

What I've done reasonably well 

The single most effective thing I've done is save on a regular basis.

Whether my zeal for saving reflects an innate impulse, a reaction to my family's precarious financial situation as I was growing up, a rational decision to stash away money for the future or a combination of these, I can't say. But I can say that for whatever reason I've always tried to live below my means and contribute the max (or as close as I could get to it) to tax-advantaged retirement plans.

For example, as a freelance writer prior to joining MONEY, I opened and funded a Keogh account and then a SEP-IRA, both of which are retirement savings plans for the self-employed.

Once I became a MONEY staffer, I made it a point to take advantage of virtually every opportunity my employer offered to save, including the company 401(k) plan, which I funded to the max pretty much every year.

I also applied the 401(k) system of automatic payroll deductions to saving outside of tax-advantaged plans. In the late '90s, I set up an automatic investing plan, directing a mutual fund company to transfer $300 a month (later increased to $500) from my checking account to a stock fund. I felt a pinch at first, but after a few months I adjusted quickly to having a little less spendable income.

Today, those monthly transfers, plus investment earnings, total in the low six figures. Hardly a fortune, but a nice little sum of what I think of as "extra" money, in the sense that I otherwise would have squandered that dough on lord knows what.

I think I've also done a decent job on the investing front. Not that I've employed any grand strategies. Far from it. My not-so-secret secret has been to keep it simple and hold the line on costs.

I've never had much faith in money managers' ability to beat the market after investment costs, nor in my ability to predict which asset classes would perform best in the short-term. So for the most part I've tried to build a portfolio of low-cost broadly diversified index funds that track the overall stock and bond markets. Then I sat back and rode the long-term upward sweep of the financial markets.

Granted, that ride has been a bit bumpy at times. But I've found that the best way to deal with the market's inherent uncertainty and volatility isn't to try to outguess it by jumping in and out of the market. Rather, it's to gauge your risk tolerance and then set a mix of stocks and bonds that will allow you to participate in the upswings while enduring the downturns without panicking and selling at the bottom.

One final trait that's served me well has been my inclination to ignore the fads, crazes and shifting fashions that pop up so often in the investment world.

I suppose a critic could see this as a failing, my inability to embrace innovation. Perhaps. But over the years I've seen too many Next Big Things (option-income funds, world currency funds, government plus funds, auction-rate preferred securities, to name just a few) implode, hurting investors in the process.

So anytime someone touted a revolutionary new exchange-traded fund, an alternative investment designed to generate all-gain-no-pain or a novel withdrawal strategy guaranteed to boost your retirement income and extend the life of your nest egg at the same time, I reacted with a heightened sense of skepticism. I recommend you do the same.

What I could have done better

Of course, with the benefit of 20-20 hindsight we can all point to things that we'd do differently given a second chance. One area where I definitely could have improved (and still hope to do so in the future) is coordinating my wife's retirement investments with my own.

You would think in these days of instant online access to investment accounts that a married couple could easily share information about how their 401(k)s and other savings are invested. But in the real world tasks like sifting through retirement accounts and making sure our various pots of savings are invested in a complementary way sometimes take a backseat to other work and family issues.

So despite assurances from both of us that "we'll definitely sort out the finances this weekend," a year slips by and my wife's 401(k) balance with a former employer still hasn't made its way into an IRA rollover or her new employer's plan.

Another place my planning fell short was in moving my retirement portfolio to a more conservative stance as I, ahem, aged. The issue isn't ignorance. I know that as you get older you should generally shift your portfolio more toward cash and bonds to preserve capital and protect against severe market downturns.

But even though every day in the mirror I saw a man approaching his 60s, in my mind I was still that young guy in the '60s. I have since gotten my portfolio in shape. But I mention this shortcoming so other people out there will remember to keep their asset allocation in line with their biological age even if mentally and emotionally they feel much younger.

Finally, I could have prepared better for my next stage of life. I'm not actually retiring. I expect that one way or another I'll continue weighing in about retirement planning, investing and personal finance. I'm also keeping my mind open, to paraphrase Monty Python, "for something completely different."

Still, leaving the place where you've spent the major part of your career is a big deal, and ideally I should have given that transition more thought ahead of time, much as I've counseled others to do. That said, you can't always plan your life down to the smallest details. You also have to be willing to leave yourself open to serendipity and chance.

So all in all the answer to your question is yes, I have largely been faithful to my own advice, despite the occasional lapse. And if it's any consolation, I've found that as long as you get the big things in retirement planning right -- save consistently, invest sensibly, avoid rash moves and ignore fads and marketing gimmicks -- you'll do just fine even as you make a few inevitable missteps along the way.

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Your Sequestered Brain Can't See Next Crash Coming

by Paul Farrell

Warning: Forget the cuts, your brain is sequestered. That's the real problem: Your Brain. That's why the economy and markets will crash, a new Dow high notwithstanding. Why it's inevitable. Bigger crash than 2008. Longer afterwards. No bank bailouts. Austerity worse than the Great Depression. Hunker down.

Listen closely: America’s big problem is our “sequestered” brains. Meaning: “to remove, isolate, set apart, retire, withdraw into solitude.” Think post-trauma stress, paralysis, amnesia, lobotomized, entranced, just plain irrational. You’re out of it, incapable of acting rational.

And not just you: Economists, politicians and media pundits all have sequestered brains. They blab on endlessly about this or that of their special interests hiding among the trillion-dollar war-and-peace sequester cuts. Blab on and on. Myopic.

Why? Their brains are sequestered too. Millions of noisy brains. But you can’t hear them, no matter what. Your brain is on a different frequency. Only hears your set channels. That happens to your sequestered brain.

In fact, our collective brain, America’s conscience, our psyche, mind-set, even our soul is sequestered. America lapsed into a trance, confused. Our entire nation’s rational brain has been sequestered, collectively “removed, set apart, isolated, retiring, withdrawn.”

Brain sequestration: read all about your biggest problem

This is also why 152 nations worldwide as well as America can’t see the light at the end of the tunnel. Why we’re blindly driving headlong into a massive economic and market collapse. Why we refuse to see it. Why? Our collective brain periodically goes through these cycles, in the economy, markets, drama, in our personal lives. But our sequestered brains can’t hear, never learn.

Still our noisy self-centered economists, politicians and media pundits blab on, telling us: this time really is different. Why? They too, says Shakespeare, have their prescribed “entrances and exits.” The script never changes. Always the same drama, bull-bears, boom-busts, recession-recoveries, prosperity and austerity. Like Lear, same play, new actors, same result, always too late, main character blinded.

Flash forward. BusinessWeek just asked: “Why won’t anyone listen to Alan Simpson and Erskin Bowles?” Two brilliant brains, they see the oncoming train: A former GOP senator. Former Clinton chief of staff. Been “touring the country almost nonstop, warning of America’s impending fiscal doom,” for two years.

Yes, they see doomsday dead ahead. But few listen.

History repeats. History teaches. But, we never learn. Our brains are sequestered, trapped, repeating an 800-year old drama that you, me, all Americans and all world leaders can’t seem to escape.

Even Harvard historian Niall Ferguson, author of “The Ascent of Money: A Financial History of the World,” admits economists Carmen Reinhart and Kenneth Rogoff’s brilliant “This Time Is Different: Eight Centuries of Financial Folly” is “the best empirical investigation of financial crises ever published.”

But “This Time is Different” is much more than an 800-year history of endless human “follies” through bull/bear, boom/bust cycles. It is also the single best book on behavioral economics ever. It exposes the shadowy side of the investor’s brain and the faux promise of behavioral economics: “Just follow our advice, and your irrational brain will become less irrational.”

Princeton psychologist Daniel Kahneman’s 2002 Nobel Prize in Economics killed that theory. Investor’s decisions are always irrational, because our brains are sequestered.

800 years of historical proof: This time is never, never different

The fact is, the market’s roller-coaster ride of bull-bear cycles will never end. It’s trapped in our brains and genes. Nobody can stop America’s endless economic, market, financial and business cycles. The big reason, Wall Street doesn’t want behavioral economists educating Main Street to beat them.

If the promises really worked, investors would wise up and Wall Street’s con game wouldn’t work. So they’ll keep replaying the script in investors brains for the next 800 years. Here’s how Reinhart and Rogoff explain the never-ending drama:

Brain sequester ... fading memories, lessons forgotten, renewed arrogance

“This Time Is Different” is a “quantitative history of financial crises in their various guises. Our message is simple: We have been here before. No matter how different the latest financial frenzy or crisis always appears, there are usually remarkable similarities from past experience from other countries and from history.”

No country is immune: “Fading memories of borrowers and lenders, policy makers and academics, and the public at large do not seem to improve over time, so the policy lessons on how to ‘avoid’ the next blow-up are at best limited.”

Delusions ... we’re smarter, learned our lessons, old rules don’t apply

“The essence of the ‘this-time-is-different’ syndrome is simple. It is rooted in the firmly held belief that financial crises are things that happen to other people in other countries at other times; crises do not happen to us, here and now.”

Each new generation convinces itself, like Silicon Valley did in 1999, that “we are doing things better, we are smarter, we have learned from past mistakes. The old rules of valuation no longer apply.” And that each new boom, “unlike the many booms that preceded catastrophic collapses in the past (even in our country), is built of sound fundamentals, structural reforms, technological innovation, and good policy. Or so the story goes.”

Similar self-delusional “stories” guarantee the cycle will repeat ad infinitum.

New technologies ... new leaders, new regulations, but same old greed

“The lesson of history, then, is that even as institutions and policy makers improve, there will always be a temptation to stretch the limits. Just as an individual can go bankrupt no matter how rich she starts out, a financial system can collapse under the pressure of greed, politics and profits no matter how well-regulated it seems to be. … Technology has changed … but the ability of governments and investors to delude themselves, giving rise to periodic bouts of euphoria that usually ends in tears, seems to have remained a constant.”

Excessive debt ... one common problem repeating in all crises

“If there is one common theme to the vast range of crises … it is that, excessive debt accumulation, whether it be by the government, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom.”

Our brains are sequestered, too irrational in good times as well as bad. “Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang — confidence collapses, lenders disappear and a crisis hits. …”

Blinded ... credit fuels success, arrogance, warning signs missed

Reminds us of 1999.“Highly leveraged economies … seldom survive forever … history does point to warnings signs that policy makers can look to access risk, if only they do not become too drunk with their credit-bubble-fueled success and say, as their predecessors have for centuries, this time is different” as leaders and followers all stay “too drunk,” till too late.

“This Time Is Different” should be in every investor’s library — it’s the best description of our financial history, the impact of behavioral economics and why your sequestered brain is the real culprit in Washington’s sequestration drama.

Looking back 800 years, we now know bull-bear cycles are inevitable. The reason? Because our brains are sequestered, forever vulnerable to this endless roller-coaster ride. And why, right now, the cycles are again peaking, will crash, making the right exits, then the next entrance.

No, this time really is not different. And, unfortunately, Reinhart and Rogoff also tell us that in the process our sequestered brains are also sabotaging capitalism, damaging America’s role in the world and, sorry to say, killing your retirement.

Worse, the cycle will go on for another eight centuries.  Prepare to hibernate.

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