Retirement Scapegoats Gone Wild: Compound Interest Edition

Sixty-one percent of Americans expect to work past the age of 65. Why? Well, we all know the real reasons: lifestyle inflation, wasteful and hilarious financial behavior, and undisciplined savings. However, rather than accepting these reasons and taking charge of each’s own situation, we would rather take comfort in blaming external factors for the retirement plight. Take your pick: income inequality; the movement to 401(k)s from traditional pensions; the shrinking middle class; stagnant wageshealth care costsinflationdeflation… What’s your fancy?

There was already a buffett of excuses for why the math of retirement doesn’t work for you. Now, thanks to U.S. News, I can finally say I have seen them all. Apparently, the math of retirement doesn’t work because math itself is to blame. What Einstein called the eighth wonder of the world, compound interest, apparently ain’t so compound-tastic, after all.

The appeal of compounding is obvious, or at least I thought so. With a little bit of effort and the magic of time, even small amounts of money when invested and left alone can turn into huge sums of wealth. Your money makes money and that new money makes more money, and so forth, like a snowball rolling down a hill. Compound interest is how investing just one dollar per day at 10% per annum for 45 years, starting at age 20 (so a total of $16,245 put in), somehow becomes $324,710.09 at age 65.

Compound Interest: The Fallacy

So, U.S. News, have I been misinformed? Are the laws of mathematics no longer valid?

Well, author Joanne Cleaver says that the math is fine, but the way compounding is portrayed as a “magic carpet ride” is faulty. In her editorial, she cites Texas Tech Professor Chris Browning, who states:

“I hate the way it’s sold to people as though it’s a lottery-winning strategy,” Browning says. Compounding, he says, “is not as amazing as people sell it to be.” That’s because the simple compound interest equation is simultaneously eroded by five factors: fees, inflation, taxes, market performance and the other ways you could spend your money.

 

Hmmm, let’s take those five factors one at a time.

Fees: The Center for American Progress found that the average 401(k) plan has fees of 1% of assets. That 1% fee sucks, as it would reduce that $324,710.09 from our example above to $228,600. However, it’s a well-known fact that nearly all actively managed funds underperform the broader indexes. So, what the heck are you paying fees for? Probably because you either have to based on your plan sponsor, or you erroneously believe that your portfolio manager provides lasting outperformance (which they do not, unless your portfolio manager is named Madoff). That’s why getting your money into low-fee index funds is often a great way to go. Vanguard’s S&P 500 ETF, VOO, carries a minuscule 0.05% fee, which means that $324,710 drops to $319,000. And then there’s dividend growth investing. If you’re comfortable with that sort of thing, it might be a good idea for you, as there are no fees at all.

Inflation: Inflation tends to not affect retirees as much as you might think. Yes, prices rise over time. But, as you grow older and kids graduate, houses and cars get paid off, and you start living off-peak, you tend to buy less. Inflation still has an impact, but more along the lines of 1 to 1.5% per year, as decreasing expenditures offset its full effects. Another thing I don’t think the author understands is that inflation sinks all boats. Have you ever seen what inflation does to the purchasing power of money hidden under a mattress? It’s a whole lot worse than what it will do to money invested that is compounding in growth.

Taxes: As Cleaver continues to paint a grim picture, she says, “It gets worse: You’ll have to pay taxes somewhere along the line.” Well, not always. If you’re smart about your investing and withdrawing, you can avoid paying taxes going into and coming out of retirement accounts (even if you withdraw in your thirties). In taxable accounts, taxes are due only on capital gains and dividends paid. If you utilize a smart tax-loss harvesting strategy and avoid active trading, you’ll have little in the way of capital gains. If you’re in the 10 or 15% tax brackets, qualified dividends are tax free, and then only taxed at 15% for the 25 and 35% tax brackets. And, consider the alternatives. Ordinary income is taxed in about five different ways (State, Federal, Medicare, OASDI, and sometimes municipal income). Then, the act of spending money subjects you to any of thousands of consumption, sales, or sin taxes.

The government will always get theirs. But, saving for retirement and investing in compound growth vehicles is the best way to ensure they get as little as possible. It’s no secret that the rich get richer, and this is largely because the rich make their money in ways that avoid most taxes.


Market Performance:

The markets, Browning says, might not cooperate with your plan and deliver a steady 7.5 percent annual return. That will affect the power of compounding.

 

Wait, might not cooperate? I’m gonna go out on a limb and provide a rock-solid guarantee that markets will not cooperate. Over a given year, markets have been known to fluctuate rather wildly, and you should care about this if you are starting your investing today and are planning to sell everything a year from today. However, for sane, long-term investors, returns start to balance out quite nicely:

Returns By Rolling Period

Whether you go up 5%, down 20%, then up 15% or down 20%, up 15%, and then up 5%, the power of the communicative principle says that all that really matters is your compound annual growth rate, and as I’ve expressed at length, that is about 11.17% per year in the S&P500 after reinvested dividends. What’s more, if you dollar-cost average into your investments, the returns are even more balanced.

Other Ways To Spend Your Money: Downplaying compound growth because there might be better ways to spend your money is a bit like saying, “That movie sucked, because I’d rather have been skiing.” Depending on the interest rate, it sometimes may be a better idea to pay down debt than to invest, but that certainly doesn’t place fault on the power of compounding. There are many things you can spend your money on: chicken sandwiches, a home, financial independence, lawn gnomes, etc. If you want to spend your money on something other than buying your freedom, that’s just fine, but don’t pretend like that’s not a choice

What The Heck Is Your Intention?

So, I ask you, author Joanne Cleaver, what exactly is your intention with deriding compound growth? Is it your hope to discourage a population of grossly inadequate savers to completely throw in the towel? Would you prefer that we save nothing, spend everything, and blame every factor under the sun—including the savings equations themselves—for how difficult retirement is?

Well. Newsflash: we’re doing that just fine without you and your misinformed article.

Thanks for reading Retire29, and not for reading U.S. News.

Eric

8 Comments

  1. Thanks for the post Retire29. In my way of thinking, the trouble is that we’ve simplified the compounding interest idea too much. Reducing it essentially to parabolic curve…..always going upward to the right (which typically is shown as the future). I think as long as investors realize that the factors you listed above ERODE that return, no problem.

    I hope you guys have a great weekend
    -Bryan
    Income Surfer recently posted…Union Pacific: My ReviewMy Profile

  2. This post is great! The media feeds the consumerism, “the sky is falling” mentality that pervades America (and I assume elsewhere). Everybody hears every day that you can’t retire any more (backed up by depressing statistics) and how saving is useless because you can’t afford to retire (reference above stats). You can always find an excuse not to save. The same people who can’t afford to retire also live in a mcmansion, drive a new SUV and have $200 cable packages not to mention how often they eat out.

    As an investment analyst, you are well aware of how easy it is to find a set of “statistics” that back up your claim.

    Does anybody have any good ideas on how to talk to people about this? Is there a way to broach “hey, are you planning on eating cat food in retirement? Because with the way you’re spending…” without sounding like a pompous ass? I’ve mentioned casually to a few friends that I won’t be working (in a typical fashion) once I’m 35 and they can’t comprehend. They’ve even tried to cut me off. (Note to self: don’t drunkenly divulge future financial plans.)

    • What Up Stuff!

      It’s never an easy conversation, and I’ve given up having it. Those on the receiving end tend to feel like you’re selling them something, and get a little turned off by it. There are HUGE psychological barriers we are up against, and those barriers are reinforced every day. Every risk is highlighted for our path, and every risk is downplayed for the traditional path (doesn’t anyone see a risk in not pursuing your passions for fifty years?).

      Anyway, best to just live by example. One day, when I retire, I won’t have to convince, as I’ll be living proof.

      Eric

  3. Yep, that’s the harm with articles like this, it discourages people from investing in benefiting from it long term.

    My Mom did not save and now she struggles from social security paycheck to social security paycheck. And she still spends more than she makes.

    Now, had she saved properly and let compounding kick in, she would not be struggling today. That’s the plain truth.

    Do I help her? Yes. But I still can’t get her to change her ways.
    Steve Miller recently posted…Don’t Worry Be HappyMy Profile

  4. I was thinking the same thing when I first read the article. I’m think it’s a clickbait contrarian view as the reason for the message. One things is for sure…you cannot defy the laws of mathematics…they do not fail. The author made some valid points regarding fees, taxes and inflation…so I’m glad you explained the fallacy of her arguments!
    Andrew@LivingRichCheaply recently posted…Life Insurance and Credit Card Debt Discussion with Co-WorkersMy Profile

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