How the Rich Became Rich

Shera Dalin: Welcome to the St. Louis Fed’s Timely Topics podcasts. This is Shera Dalin, your host for this episode. And today I’m speaking with Serdar Ozkan, research officer with the Federal Reserve Bank of St. Louis. Thanks for joining us today, Serdar.

Serdar Ozkan: Thank you for having me, Shera. It’s my pleasure to be on the podcast and share my research. I’m a big fan of Timely Topics.

Dalin: Love hearing that. So you’ve been studying how people accumulate wealth, and you looked at one group of people over a 20-year period. Some were rich to begin with, what we might call “old money.” but others had more modest means, what I’m calling “new money.” So who were these people, and why did you choose to study them?

Ozkan: We use administrative data from Norway, covering the entire population. Norway is one of the few countries we can follow the same individuals, including the wealthiest, over a long period of time. We get to see their wealth, income from different assets, labor income, inheritances and savings. For example, we don’t have any data set for the U.S. that allows us to see how the current wealthiest households were able to develop such large portfolios over their lives. Did they start with a large amount of assets by the help of wealthy parents? Or have they invested in high-return assets such as private businesses? Or were they saving a much higher portion of their income to invest? Or were they just high-earnings workers? These are the questions we study in this project.

Dalin: Great. And are these people who rose through the corporate ranks to become wealthy, such as starting out as a clerk and eventually rising to become a CEO?

Ozkan: That’s a very good question, Shera. This was actually one of our conjectures when we started the project. So, when we look at the current wealthiest, say among 50-year-old or so households, and follow them back to their mid or late 20s, we see that, on average, they already owned a large amount of assets. And these assets were mostly in the form of private businesses. Interestingly, we see that some of these private firms are partly owned by their parents at some point. So we think that at least some of the wealthiest got a big push from their parents early on in their lives.

But, of course, not everybody started their lives wealthy. Around 20 to 25% of the current top 1 or top 0.1% households are coming from modest backgrounds. This group of wealthy individuals, whom we call “new money,” had less than median wealth in their mid-20s. We looked at their parents and they’re also not very wealthy either. Only a few of them are in the top 5% of the wealth distribution. So these new money households can possibly be the ones that rose through the corporate structure to become a CEO and get rich.

And, yes, we find labor income to be more important for this group. But we still see them invest increasingly more in private businesses in their portfolios over their lives and earn very high returns from them. As a result, income from these businesses become more important than their labor income.

Dalin: And, since you had data for 20 years, what did you discover about how these people accumulated wealth over that period?

Ozkan: So, as I was saying, both new money and old money households are heavily invested in private businesses, which earn very high returns relative to other assets. For example, if you invest in safe financial assets such as bonds and savings accounts, you only earn around 1 or 2% a year. Real rate of return on housing is higher, but still around 4-5% annually. However, return on private equity, some of which you can think of it as entrepreneurial income, is much higher and on average more than 10% per year. Actually, this number is even higher for new money households who earn around 20% on their private equity investments.

So these wealthy households, by investing mostly in their own businesses, they achieve to compound their wealth at a much higher rate than the rest of the population, for whom housing is the single most important asset in their portfolios.

Private businesses are also very important for wealth concentration in the U.S. Other researchers have documented that 12% of households who own a private business account for around 45% of wealth in the U.S. Most top earners are business owners. In 2014, around 70% of the top 1% and 85% of the top 0.1% earned some private business income. So our finding is not specific to Norway.

Dalin: So, once people become wealthy, how did they retain their wealth?

Ozkan: That’s a very good question. Higher rates of return is not the only story here. Yes, the wealthiest can compound their wealth at higher rates thanks to their private businesses. But we find that they also have much higher savings rate than the rest of the population. For example, on average, median households set aside roughly 20% of their income for savings. Whereas the top 0.1% wealth owners save a staggering rate of 70%. So it is more than three times as high as the saving rate for the median households.

High saving rate is another key factor how the rich accumulates their wealth and retain it. I suppose, if you are living paycheck to paycheck, it’s not possible for you to save more than 20% a year. But, if you earn so much, you can easily set aside more than 70% of your income and still live very comfortably.

Dalin: That’s a good point. When you look at those numbers, it does seem to be the case. So, logically, I would think that people who started out wealthier, the old money group, would be richer at the end of the 20-year study period because they have access to more capital, connections, and savvy acquired from family and their social network. So was that the case?

Ozkan: Actually, yes. This seems to be the case. So, as I was mentioning earlier, even in the early stages of their lives, old money households are heavily invested in private businesses, and specifically in the firm that their parents also owned at some point. So it seems that they are taking over their parents’ businesses through which they get access to more credit, a larger customer base, a wider social and business network. All these things help them to learn the business quickly and run the firm more efficiently and earn higher returns. For example, if we are looking at top 1% today, both groups end up in the top 1%. But these old money guys are still, on average, a little bit wealthier than the new money guys, right? If we look at top 0.1%, the story still holds.

My guess is that if we can continue looking at this for another 10 years, 15 years, maybe we will see them actually converge in the end.

Dalin: Very interesting Serdar. Let’s pause here for a quick break.

The Federal Reserve Bank of St. Louis brings you the Timely Topics Podcast Series. We talk to research economists and other experts from the Federal Reserve about their latest research and other topics in the news. You can find all our Timely Topics podcasts on stlouisfed.org or wherever you’re listening right now.

We’re back to discuss wealth accumulation with Serdar Ozkan. So I’m curious about what your data show in the variation among different demographic groups. For example, how did women fare?

Ozkan: We do our empirical analysis at the household level, which we think is the natural unit of decision making for saving and investment. So couples own assets and liabilities jointly, and they decide together what to do about them. But, when we look at the head of households, though, which we define as the higher earning spouse, we find that there are 20% of the top wealth owners are households with female heads. So we can say like roughly 20% have a female head of households.

Dalin: What implications does your research have on how tax systems are organized?

Ozkan: So answering this question requires a systematic evaluation of equity efficiency trade-offs. So, yes, you can reduce the wealth concentration, wealth inequality, by taxing the wealthy and redistribute it to poorer people. But you don’t want to hamper incentives of the productive entrepreneurs to invest because they are the ones who are going to create jobs, you know, in turn lead to higher wages and bigger wealth increases for everyone.

Our preliminary results suggest that taxes on inheritances reduce wealth inequality but also lowers output and employment because the old money wealthy are also productive entrepreneurs, as we infer from their high returns in the data. So we have to pay attention to that trade-off.

Dalin: So the big question that a lot of people will want to ask you, Serdar, is do you have any advice for people who want to get rich?

Ozkan: I got this question a lot. Well, it seems that if you have a good business idea, starting, building, investing in your own business seems to be the most common way of becoming wealthy. But it’s a risky business, though.

Dalin: Good point. Great risk, potentially great reward.

Ozkan: Exactly.

Dalin: Or catastrophe. It could go either way.

Ozkan: So...

Dalin: Well, thank you for sharing your research with us, Serdar. And we look forward to learning more about your upcoming work.

Ozkan: Thank you, Shera. This was really fun.

Dalin: Likewise. For more from our Timely Topics podcasts and to read Serdar’s analysis, visit the St. Louis Fed’s website at stlouisfed.org. You can also stream and subscribe to all our episodes on Apple Podcasts, Spotify, or your favorite podcast app.