Sequence of returns
The dark side of compounding
Is best avoided

Albert Einstein famously said that “compound interest is the 8th wonder of the world.” But that isn’t the end of the quote. He went on to say: “He who understands it, earns it; he who doesn’t, pays it.”

Retirement income planning is much different than income planning during working years. During your working years – the “accumulation phase” in finance speak – your earnings have to do a lot of work. They must support your household expenses PLUS your household savings. During this phase of life, income is based on the market price of the job you have, not the cost of your standard of living. This can lead to a high tax rate, regardless of spending.

During retirement – or the “distribution phase” – you don’t need as much income because, theoretically, you are spending your savings, not adding to them. Secondly, your income in retirement is based purely on your spend rate. Many retirees spend less money as they age, which means a reduced income need, which means fewer withdrawals from investments, which means lower taxes. These are good things for people trying to make their savings last as long as possible.

However, the savings portion of your retirement income is where compounding interest can reveal its dark side.

What is the dark side of compounding?

Let’s take an account worth $1,000,000 as an example. Let’s also assume we’re back in the nightmarish days of the Great Recession when, from October 2007 until February of 2009, the Dow lost nearly 50% of its value.

In this scenario, our $1,000,000 becomes $500,000. That’s a 50% loss. But what if we get a 50% gain the very next year? On a spreadsheet, our average annualized returns would be 0%.

But a 50% gain turns our $500,000 into only $750,000. A 50% loss followed by a 50% gain produces a net return of -25%. What on earth is happening?

In order to restore your $500,000 back to $1,000,000, you would need a return of 100%. This is what Mr. Einstein was warning us about. This is the dark side of compounding.

In a down market, losses require a percentage gain greater than the percentage loss in order for the investor to restore his or her account back to its starting point.

If you are in your earning years, market losses are not a problem. In fact, for working people a crash is a great opportunity to invest at a discount. This is what Warren Buffet meant when he said “be greedy when others are fearful.” This is also what is meant by the phrase “buy the dip.”

Having a stable income stream means you can wait out a crash and recovery. However, for retirees needing to withdraw money from their savings, a market crash is a disaster.

Let’s say a retiree, we’ll call her Mrs. Example, is using the 4% rule and is withdrawing $40,000 from her $1,000,000 account every year. 2007-2009 happens and Mrs. Example’s $1,000,000 turns into $500,000. Mrs. Example needs the money for her retirement expenses, so she withdraws $40,000.

Now Mrs. Example’s account is down to $460,000.

But the market bounces back. Yay! Mrs. Example gets the same 100% return we discussed above.

But what does a 100% return do to $460,000? It turns it into $920,000. Her $40,000 wasn’t in the market to participate in the recovery. Her $40,000 withdrawal turns into an $80,000 loss in this scenario.

The problem here is not the stock market crash. The problem is failing to plan for the crash.

Market crashes are like wildfires. They are horrific in the short term, but beneficial in the long run. Moreover, some economists believe that they are a feature of a healthy system, not a bug. Much like wildfires, an argument could be made that by trying to avoid market losses altogether, we will only make them catastrophically worse when they finally do happen.

The lesson is that market crashes are unavoidable. Some economists believe they actually need to happen from time to time.

A good income plan will survive a financial wildfire. How? By allocating to defensive positions when times are good. The purpose of the defensive portion of a portfolio is to maintain money’s purchasing power without taking significant risks. This strategy allows a retiree to avoid having to touch market investments when they are on fire.

A great income plan will let a retiree wait out not only a crash, but also the recovery. In the case of the Great Recession, it wasn’t until September 2013 that the S&P 500 index was back to its October 2007 levels; nearly six years from start to finish.

Is your retirement income resilient? Could you go six or seven years without touching the “offense” portion of your investments when another Great Recession happens? If you’re not sure, we’re here to help.