How Falling Interest Rates Widened Americans’ Wealth Gap

When economists talk about wealth inequality, they often focus on assets people can buy and sell, such as stocks, bonds, and real estate.

Those long-term assets performed spectacularly well in the low-interest-rate environment that began in the United States after the 1980s, when asset values skyrocketed. That’s one reason why Baby Boomers were able to sock away lots of money for retirement while Millennials have faced lower lifetime investment returns from the outset.

Yet just looking at marketable assets misses the full picture of household wealth, according to new research from James Paron, an assistant professor of finance at Stanford Graduate School of Business, and coauthors Sylvain Catherine of the Wharton School at the University of Pennsylvania, Max Miller of Harvard Business School, and Natasha Sarin of Yale Law School. They find that looking at “total wealth” provides a clearer picture of disparities in Americans’ wealth and how possible cuts to Social Security would affect lower-income households.

“At the end of the day, people consume not just out of their marketable wealth, but also out of their total wealth,” Paron says. “It’s misleading to look at marketable wealth inequality alone, because we’re missing a huge chunk of wealth that people at the bottom of the income distribution eventually consume.”

Total wealth includes not just obvious sources like home equity or 401(k)s, but also two off-balance-sheet sources: human capital and Social Security. Human capital is employment earnings, which operate like a long-term bond delivering cash flows over a lifetime. Social Security functions like a long-term government bond that pays an inflation-adjusted annuity in retirement. These two assets form most of the total lifetime wealth of young and low-income households, who don’t hold much financial wealth for retirement.

Factoring in these “hidden” income streams, Paron and his colleagues found, makes wealth inequality behave in a more nuanced way than traditional models suggest. When interest rates decline, the resulting asset boom disproportionately increases the wealth of the rich, who have less need for Social Security and hold more of the long-term financial assets that are most sensitive to interest rate movements. That dynamic alone explains about two-thirds of the rise in U.S. wealth inequality since the 1980s.

A Lifetime of Returns and Risk

Using data from the Survey of Consumer Finances, the authors built a life-cycle model of how a household optimally accumulates wealth, owns or rents housing, and invests for retirement. They then tested this model by simulating how five generations, from the Greatest Generation to Millennials, lived through U.S. economic history since 1880.

The researchers found that, whether consciously or unconsciously, most Americans construct a portfolio of assets whose interest-rate exposure closely matches what’s optimal given their total wealth. Those portfolio decisions reveal an underlying logic: Because Social Security functions like a bond that pays a fixed amount no matter what interest rates do, households that rely on it heavily in retirement are already hedged against the risk that rates will fall and future investment returns will drop.

High-income households that don’t rely heavily on Social Security have to build that same hedge using long-term financial assets such as stocks and bonds. These assets let them generate returns today rather than face the risk of low rates in the future.

“What long-term assets allow you to do, like a long-term bond, is lock in a rate of return today, hold it until retirement, and consume what it pays out when you retire,” Paron says. Low-income households, by contrast, hold few long-term financial assets and instead rely on future Social Security benefits to fill that role. They may look unprepared for the risk of poor returns on savings in retirement, but Social Security hedges their interest-rate exposure much as stocks and bonds do for the rich.

What If Social Security Is Cut?

These findings bear directly on the debate over Social Security reform. The authors modeled the roughly 25% cut in benefits that will be required to close the program’s long-term funding gap when it runs out of money in 2032 (if Congress does not act before then).

Social Security is a progressive program, Paron explains, since it “replaces” more retirement income for every tax dollar low-income households pay into it than it replaces for high-income households. So it’s unsurprising that cuts would disproportionately hurt the poorest households that rely on those benefits. One way to lessen the impact could be making the cuts larger at the top than the bottom, or raising taxes at the top to finance the shortfall.

“More interestingly, we find that the cut would be most harmful if it occurs at a time when interest rates are low,” Paron says. “Social Security protects low-income households against low rates, meaning bad future returns. So taking away those benefits when rates are low removes them precisely when they are most needed.”