I recently had a conversation with my teenage daughter where we had reason to consider the financial situation of an elderly couple that are family friends. My daughter became aware that this family had an (undisclosed) amount of money to live on for the rest of their lives, and that was it. She made an off-hand remark that “they have that amount of money to live on, and that’s it? That would stink.” This caught my attention because my daughter didn’t know how large the pile of cash was. In fact, it was quite large, easily qualifying our friends as wealthy by any reasonable standard. What if she had known the amount to be $100 million? Would that have changed her perception? Maybe. Maybe not.
Sometime later, I saw a post on a financial blog titled something like “I’m 70 and Can’t Spend My Money!” And a few days later, I became aware of a research study that found that high-income retirees spend more money than otherwise similarly situated high-net-worth retirees.
All of this had me reflecting on the fundamental psychological and behavioral differences that accompany wealth versus income. At first blush, wealth appears to be non-renewable—a veritable wasting asset. Income, on the other hand, appears to be self-replenishing and perpetually renewable. My theory here is that these intuitive surface-level perceptions can get us in financial trouble.
Defining Wealth and Income
The fundamental distinction between wealth and income has been well-documented in various writings of Dr. Stanley, including in The Millionaire Next Door and other publications. Income refers to periodic cash inflow, and wealth refers to accumulated assets. Stated more practically: income is what comes in the door periodically, but wealth is what the recipient manages to hang on to and accumulate.
Although fundamentally different things, the two concepts share an intertwined relationship; absent a windfall (think inheritance), income is absolutely necessary to build wealth. Wealth, in turn, can generate income on its own as a pleasant by-product.
Maybe in part because of this symbiotic relationship, there is no shortage of confusion among the general public and in the popular press about these two concepts. The media will often refer to a high-income individual as “wealthy,” but this is often incorrect. They have a healthy income (and consumption to prove it), but little in the way of accumulated assets and therefore do not possess wealth. If you earn $1 million and spend $2 million in consumption, you certainly are “high income,” but you’re also broke. This reminds us of the terminology used by Dr. Stanley in The Millionaire Next Door: high-income, no assets are the “income-statement affluent.” Those who have actually converted their income into wealth are the “balance-sheet affluent.”
The two can be and often are very different in their psychology and behaviors. Here we attempt to take a deeper look at those psychological and behavioral differences and their potential causes and effects.
The Superficial Analysis of Wealth and Income
At first blush, as expressed by my high-school-age daughter, wealth represented simply as a pile of money appears to be finite. Exhaustible. Wasting away with every dollar spent. This perception, it would seem, can bring along a host of undesirable psychological and behavioral tendencies.
Income, on the other hand, appears to be perpetually renewable. Inexhaustible. Self-regenerating. When the next installment of income is just around the corner, why not spend the prior installment today? Again, it is intuitive to see how this perception can also lead to undesirable financial consequences.
The trouble with these surface-level perceptions of wealth and income is pernicious. The erroneous view of wealth can lead to under-spending, reduced enjoyment of financial assets, and even hoarding. The erroneous view of income can lead to profligate levels of spending, failure to accumulate valuable assets, and financial ruin if the assumed renewable income is for some reason cut off. The allure of acting wealthy right now on the basis of high income (and high consumption) can lead to a situation where real, lasting wealth is never achieved.
In light of these alluring and yet confusing surface-level misperceptions about these two critical financial concepts, it should come as no surprise that wealth and income are not highly correlated in many research studies. So while income certainly is a precondition for real wealth, it clearly is no guarantee.
Relevant Research: More Income Equals More Spending (and Less Wealth)
Recent research supports the conclusion that more income—both in frequency and amount—leads to higher levels of spending and thus lower levels of wealth.
Increased Income Frequency Leads to Increased Discretionary Spending
A 2021 study by two researchers at Stanford University (the “Stanford Study”) concluded that the frequency of income installments had a significant impact on the amount of discretionary spending undertaken by the individual recipients. The Stanford Study indicates that if you take the same overall amount of income and simply break it out into smaller but more frequent income installments, the recipient generally showed higher levels of discretionary spending.
What accounts for this apparently irrational change in financial behavior? The researchers found that the increased frequency of the income installments led individuals to a heightened perception of their wealth. This phenomenon stems from the different way we perceive what are referred to as “aggregated” versus “segregated” gains: we seem happier with more frequent, smaller gains spread over time as opposed to one lump sum. For example, we prefer to receive $5 a day for 5 days than to receive $25 on one day in a lump sum (note: those of us that think in terms of time-value of money calculations know better!). We feel richer in the periodic income scenario than in the lump-sum scenario, even if they are identical in absolute terms.
Now apply this powerful insight to the real-world personal-finance scenario of considering the psychological difference between the receipt of $10,000 per month as salary versus a store of $1 million of previously earned money in the bank. The cool million lump sum might make you feel good, but it will likely be harder to spend than the $10 grand that you know will simply be replenished in a matter of days. Indeed this is understandable—doing the math and Monte Carlo analysis to support a bullet-proof draw-down rate on the lump sum is difficult and scary. It’s uncertain—no matter how good your spreadsheet analysis may be. We like certainty. It gives us warm and fuzzy feelings.
What is clear from this research is that income makes us feel wealthy, even if in reality, we are not accumulating any lasting wealth because we’re perpetually spending the renewable income.
Confirmation: “Guaranteed Income” Equals License to Spend
Back to my high-schooler: she intuitively understands the idea that we don’t like watching our nest egg shrink. It’s human nature. A 2021 study by researchers David Blanchett and Michael Finke (the “Blanchett Study”) put some data behind this idea to get a sense of the magnitude of this psychological and behavioral phenomenon, and the results were striking.
The Blanchett Study compared the spending levels of two groups of retirees with identical wealth levels: one with a lump sum of investment assets, and the second with the same amount of wealth in the form of annuitized assets that provided periodic guaranteed income. (The amounts of wealth were identical between the two groups because the present value of the annuity income equaled the present value of the lump sum investment assets.) The study found that the guaranteed-income group spent twice the amount as the lump-sum group. Thus, a retiree household with a generous pension and zero savings will likely spend twice as much as a household with enough cash money to buy an annuity that provides the same income as the pension.
The authors of the Blanchett Study refer to guaranteed-income wealth as a “license to spend” accumulated savings, and their findings certainly make a strong case for “annuitizing” at least some part of accumulated wealth to overcome the significant psychological roadblocks otherwise encountered in the retirement-phase draw-down of wealth. (The Blanchett Study also notes that roughly 25% of retirees do not have a clearly defined draw-down strategy, such as a 4% withdrawal rate. It appears—unsurprisingly—that those who do are both happier and better at spending their accumulated wealth in retirement. But this also highlights the reality that confidently calculating a fool-proof draw-down strategy can be both hard and scary.)
The Good and the Bad of (Apparently) Inexhaustible Income
This research exhibits both the good and the bad elements of reliable, periodic income. The good: it can give us the confidence to spend and draw down accumulated wealth at a time in our lives when that is the very objective (i.e., retirement years). The bad: it can lead us to spend more instead of saving and accumulating at a point when building wealth is a primary objective. The harsh reality is that the dark side of periodic income comes first in sequence in most of our lives; if you don’t treat your earned income as if it won’t last forever during your working years, well, then you may have to work forever to ensure that it does. If, on the other hand, you can successfully convert your income to wealth during the working years, you’ll be able to later convert that wealth to income when your objective is to spend it down.
With these concepts in mind, we can distill our learning down to two simple rules to govern (1) our working years and (2) our retirement/draw-down years:
- Working years: focus on converting income to wealth. Get this right, or you may never be able to stop working and generating income. And remember: it may not be up to you when you are required to stop laboring in order to generate income.
- Non-working years: focus on converting wealth to income. Get this right, or you may never fully enjoy the wealth you built during the working years. This can be done through any number of alternatives ranging from annuities, fixed-income securities (bonds), or simply a well-designed, conservative withdrawal rate in which you can have confidence.
Don’t Let the Superficial Appearance of Periodic Income Warp Your Saving and Spending Behaviors
Income is alluring, exciting, and at the same time calming, but don’t let these surface-level perceptions take you off course. If you have high wealth but low guaranteed income, don’t let this ruin your ability to consume and enjoy your accumulated wealth. If you’re high-income and low wealth, don’t let your healthy periodic inflows destroy your chances of building lasting, enduring wealth. Every earned dollar of income can serve as a goose that lays gold eggs for a lifetime—or even multiple lifetimes—but only if you don’t consume it first.