Make Hay While the Sun Shines

Many people tend to think that the Top 1% of income earners in America is a fairly ubiquitous group that tends to stay consistent through time.  In fact, nothing is further from the truth.  The odds of getting into the top 1% of income earners are higher than most think, while the odds of staying there are far, far lower than most think.  A 2016 study by Tom Hirschl of Cornell University and Mark Rank of Washington University in St. Louis highlights some of these important facts.  Note that this is just income – the top 1% based on wealth tends to be much stickier.

At some point in their lives, at least 50% of Americans will find themselves in the top 10% of income earners (~$100,000 or more per year).  Even better, about 11% of Americans will be in the top 1% of income earners (~$330,000 per year) for at least one year in their lives.  That’s the good news.  The bad news is that it’s incredibly difficult to stay there for any length of time.  In fact, the turnover in the top 1% of income-earners is quite surprising.  94% of Americans who get in the top 1% will only reach that level for a single year, while 99% will leave the top 1% within a decade.  Since a picture is worth a thousand words, it looks something like this:

People move up and down the income quintiles and percentile groups throughout their careers and lives.  Very few people, if anyone, experiences consistent upward growth in income that puts them in the top 10% or 1% of income earners for most of their careers.  The same holds true at the bottom as well.  Income generation tends to be inconsistent throughout most people’s working lives.  This fact just tends to be particularly true, and possibly more painful, at the very high end.

Variability at High Income

While all groups of people experience income variability, the highest income earners tend to experience it the most.  Compensation structures change after a certain income point, which introduces greater upside potential but also greater risk on the downside.  Once you become a high income earner, a relatively smaller and smaller share of your total compensation is driven by salary.  Very few people have $500,000 salaries that go up 5% each year.  Instead, most have a salary plus bonus, commission, or stock option structure.

Let’s take a look at some common types of jobs with different compensation structures that could lead to a 1% income, but would also be highly variable.

  1. Sales: A business can’t exist without selling a good or service to its customers. It’s far easier for a troubled business to grow its way out of problems through greater revenue than it is to cut expenses.  Customer acquisition and retention is one of the most important functions of any company and it tends to be handled by salespeople.  Sales professionals are commonly compensated by a salary plus commission model.  For example, at the investment management firm where I used to work, our sales team received a decent salary (~$100,000) but also a commission based on new client acquisition.  They could earn up to 20% of all revenue from a client’s first year, 10% of year two’s revenue, and 5% in year three.  It was a declining scale in order to incentivize new business.

This structure is great in most years for a growing firm, but can also be fairly lean at times.  A $100,000 salary is just fine in most metropolitan areas, but it doesn’t even crack the top 10% of income earners.  The years following the Global Financial Crisis were lean, but the last few have been pretty fat.  A salesperson with this type of structure could theoretically earn in the millions if they bring in large amounts of new business, but could also spend years in the low six figures.

  1. Upper Management/Techies: While these two groups of people don’t seem like a natural fit, their compensation structures are both dominated by one thing – stock options.  Stock options are the common name for a number of different equity compensation packages, including incentive stock options, nonqualified stock options, restricted stock units, and outright shares of stock.  For our purpose though, all of these mean one thing – the ability to have a huge year or two if the stock of the company you work at pops and you sell your shares.

Imagine you were a relatively early employee of Dropbox, which went public in just the last few months. You’ve worked there for five years and now have 75,000 vested options with a strike price of $1.  With the current stock price north of $30, you could exercise all of your options and earn over $2 million for the year.  Most executives and tech employees do this over several years, but nonetheless, you can see the power stock options can have in producing a large income.  This can also work in the opposite direction.  Shares of Snap Inc. are still trading below their IPO price.  Picking the right time to exercise can be incredibly important, as any employee of Facebook or Google can tell you.

  1. Investment Managers: Investment managers are a good example of employees with a bonus payout structure based on performance. In this way, they are not very unlike salespeople, but the difference here is that the bonus payout is based on something other than sales, most often a combination objective and subjective performance review.  It’s not a pure commission, although most of the time it’s related to how well the firm did that year.  These employees also tend to have a higher base salary than salespeople, but with less upside potential.  For example, I have a base salary plus performance bonus.  My salary is higher than a typical salesperson but my bonus is capped at the same amount of my base pay (it’s often very difficult to get max bonus in these types of structures).  I have no ability in my current job to earn in the seven figures.

I use investment managers only as an example, mainly because I am most familiar with this.  However, many industries use a salary plus performance bonus model.

  1. Business Owners: Finally we come to business owners. This should be a fairly straightforward example as most people understand how up and down a business can be.  A business owner’s compensation will be based primarily on how well the business is doing along with how much they want to reinvest in the business.  Small business owners in particular have wild swings in income.  Any retail or leisure based business probably struggled in the years following the GFC.  On the other hand, many are probably doing very well now.  Their compensation will ebb and flow with the business cycle and how much they can grow their business.

Steady but High Income Careers

Steady but high income careers exist, but their compensation tends to max out in the low to mid six figures range.  For example, the average anesthesiologist makes $270,000, a number that doesn’t quite put you in the 1% (that amount is the 98.7 percentile).  However, total compensation maxes out between $400,000-$450,000.  Obviously not too bad, but you’re not an ultra-high-income earner at that point.

Much like stock investors expect to earn a greater rate of return due to greater variability in outcomes as compared to bonds, those with more variable income should expect to earn more over the long run than more consistent earners.  Variable income allows the most talented employees to earn an outsized income.  Nonetheless, these careers are not for everyone.  Variable income makes it difficult to budget and save and some people just can’t handle not knowing how much they’re going to make this month.  For many, accepting lower overall compensation for more consistency is a fair trade-off.  You may never make a million dollars in any year, but odds are high that you’ll be able to stay in the top 1%-5% for a relatively long time.  Plus, variable income can be difficult mentally and even make you feel poorer than you actually are.

Not surprisingly, many of these more consistent but higher earning professions tend to require large amounts of education, so the payoff takes years to achieve.

  1. Medical Professionals: As expected, the medical professions dominate this category. Unless you’re in an administrative position, in which case you likely have a salary plus bonus model, you’ll have a very competitive salary without massive upside.  Bonus structures would expect to be very modest as well.  As mentioned above, an anesthesiologist is a good example, as are pharmacists, other specialists, and even general practitioners.
  2. Engineering: Engineers are another group of highly educated, highly compensated professionals.  Many engineering jobs start off in the low $100,000 range.  Petroleum engineers, especially given the oil shale boom in the US, are in incredibly high demand.  Mid-level petroleum engineers can earn $200,000 or more per year.  Robotic engineers can make $170,000 and instrumental/measurement engineers can make over $225,000.
  3. Lawyers: Everyone’s favorite job to hate is also one of the most lucrative.  Much like the medical professions, it requires a lot of schooling and a lot of grunt work.  Corporate lawyers are probably the safest, with salaries topping out near $175,000.  Partners at large firms can reach in the millions, but their job is more of a sales job than actual lawyering.  Of course, there are also public attorneys with incomes below $100,000, so even here, the data can be misleading.
  4. IT Professionals: IT professions have a wide range of income outcomes, but many can be surprisingly well paid. Software engineers start north of $100,000, just like other engineers.  Software architects, a more mid-level career, can get to $150,000-$175,000.  Becoming vice president of software engineering or the head of e-commerce can lead to jobs that are $200,000-$300,000 per year.

Make Hay While You Can

Given the level of turnover within the top 1% and top 10% of income earners, it’s best not to think of this income as permanent.  Obviously, much will depend on the type of job you have.  If you’re a salesperson having a great year, it would be foolish to assume you can replicate it year after year.  On the other hand, if you’re a petroleum engineer at a big oil company, it’s probably just fine to assume that your $200,000 per year job is safe for years to come.

Let’s look at the best ways to handle high income years, especially if future years are uncertain.

  1. Understand it May be Temporary: This should provide context for all of the other suggestions. When you earn a large income, know that it may be temporary and that you may only experience high income for a few years at best.  Understanding this fact helps you make investments that improve your life down the road.  Assuming an ongoing high income makes it too easy to buy high-end gadgets or lifestyle vices.
  2. Don’t Adjust Your Lifestyle Much: Walk a different path than those you find yourself with. When other techies are spending their stock option gains on big houses and fancy cars, invest yours for the future.  You never know when your company will go belly-up.  I’m not suggesting that you live like a monk, but be smart and put something aside to help down the road.  For salary plus bonus or salary plus commission jobs, find a way to fund your basic life expenses on your salary and bank a good chunk of your bonus or commission as discussed below.
  3. Be Careful with One-Time Purchases: Big one-time purchases have a tendency of raising our monthly and annual living expenses in a very sneaky manner. That big new house comes with ongoing property taxes, insurance, and repair bills.  That fancy new boat comes with a ridiculous amount of insurance and repair bills!  Try to minimize your required expenses as much as possible and think about the long-term consequences of large purchases.
  4. Bank your bonus: At least a good chunk of it. Because bonuses can be so variable, it’s best not to count on these for living expenses.  For example, we save 80% of my annual bonus and spend the rest on fun things like vacations or new furniture.  If I have a poor year, our lifestyle isn’t impacted that much.  We go on a smaller vacation or none at all, or we just don’t buy that new patio set.  It’s not the end of the world.
  5. Pay Down Debt: Use your windfall to set up the future “you” in a positive way.  Understand why you’re paying down debt or saving and investing.  You’re using your windfall to provide yourself future downside protection as well as future freedom.  Nothing makes you so beholden to a job as debt and nothing takes the weight off your shoulders quite like paying it off.
  6. Find Ways to Stay There: Finally, the best thing you can do with a high income year is figure out ways to replicate it in the future.  Be so good at your job that you can continue to have high income years on a regular basis.  For those of us not born into wealth, turning a high income into savings and investments is the best way to gain wealth.  It’s far easier to gain wealth with a high income than without.

No one can be sure of how long they’ll be able to earn a large compensation package.  In order to improve our lot in life, it’s best to assume that we won’t keep earning that high income forever and use it to help our future selves.

Keep building my friends.

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