15 Sep 2022 4 Dangers of High Incomes
If you are approaching a four-way intersection in the U.S., one that does not have traffic lights, the most common way to deal with the conflict between cars travelling in intersecting directions is to have one stop sign at each crossing. The four-way stop is so ubiquitous that it’s hardly noticeable, but as this fascinating paper pretty conclusively shows, the four-way stop is less safe, less enjoyable, and more costly than a simple alternative: Remove one of the stop signs. (For those of you nerdy enough to care, the reason for this is that a four-way stop is not a Nash equilibrium. Because all four directions of traffic are supposed to stop no matter what, there is always incentive for bad actors to run a stop sign, while also forcing good actors to all stop, wasting time and gas. A three-way stop with a fourth lane of free-moving traffic removes the bad incentive while also keeping a lane constantly moving, saving time, reducing resource consumption, and lowering the likelihood of accidents.)
Anyway, the author—a George Mason University economist named Jiasun Li—has a line in the paper that may be relevant to today’s Brief: “While it may seem arrogant to challenge a widely-adopted rule, some facts speak for themselves.”
So maybe it seems arrogant to write a blog with a title such as this one. Everyone knows high incomes aren’t dangerous, right? Certainly higher incomes are less dangerous to the extent that they prevent us from experiencing homelessness, undernourishment, and general exposure to catastrophic financial outcomes. But there are other types of danger beyond the physical, and I want to look at four that fall into those categories today.
- Echo chambers. Everyone, regardless of income, is at risk for dwelling in echo chambers. But because high income earners can and do choose typically to live among other high income earners, the risk of echo chambers is greater. Lifestyles look very similar, people start talking about vacation homes and early retirement and the usual suspects. And one of many problems with these echo chambers is that it becomes extremely easy to adopt the goals of someone whose income is much higher than yours is. You may live in the same sort of house in the same sort of neighborhood and drive the same car, but there is a huge difference between “what you can afford” when your income is $250,000 vs. $500,000 (or higher). That’s blatantly obvious when I write it out that way, but in real life we don’t know much about the actual income of our neighbors, so all we have to go on is what we see, which is consumption rather than income or wealth.
- Leverage. It’s incredibly easy for high income earners to get access to credit. Banks and financing companies prefer to lend money to someone with a bunch of W-2 income flowing into their tax return each year, even if they have bad credit. And financing can be really useful! But when you combine the ease of leverage with the problem of echo chambers, all of the sudden you put 0% down on a home with a doctor loan, and then you finance the brand new Land Rover, and then the boat, and then the…do you see where this could be a bad thing? The leverage can be a tool, but it can also quickly become a dictator, as more and more of each check is spoken for before it even arrives in your bank account.
- Under-saving. The maximum amount an employee under the age of 50 can put into a 401(k) in 2022 is $20,500. That’s a lot of money each year! But “a lot” is relative. Maxing out a 401(k) means something very different to a household with $175k in income (11.7% savings rate) vs. a household with $350k in income (5.8% savings rate), but it’s common for people to anchor to that static “max” when thinking about their saving. The higher your income, the harder you have to work to keep your savings rate where it should be, at least if you want to avoid the fourth problem…
- Retirement entitlement. When you take a cumulative look at the dangers of echo chambers, leverage, and under-saving, then the big whopper at the end is what I’m calling “retirement entitlement.” This is when saving never kept up with the lifestyle that a high income afforded, or the expensive retirement goals that often accompany those high incomes. Then, when retirement hits, there are only tough choices: Either cut spending, perhaps dramatically, or spend more than you can afford to and risk financial disaster.
In short, high incomes aren’t bad, but there can be hidden dangers lurking. That doesn’t mean we go around asking for wage cuts, but it does mean we need to be intentional to avoid pitfalls. Choosing to opt out of the comparison game isn’t easy, but it will help reduce the negative power of echo chambers. Using leverage responsibly and wisely means it’s more of an exception than a rule. Staying awake at the savings wheel will make sure you are not producing lifestyle creep (or lifestyle runaway!). And the cumulative effect of those intentional choices is a transition into retirement that isn’t fraught with forced spending cuts and panic, but rather a continuation of a life well-lived. If we can help you identify and follow through with your values and intentions, let us know.
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