While we are being regaled with unending reports on lost wealth, let's play Pollyanna and examine another aspect: an unrecognized and offsetting gain in income.
Let's examine what the market crash has done to the lifetime income of a couple who retired recently. With a market decline of more than one-third, a few months would appear to have made a gigantic difference.
As you will soon see, it hasn't.
The world hasn't ended. But it is a bit pinched.
Consider John and Jane Tipman. Both are 65. Between them, they'll receive $1,800 a month in Social Security benefits. They also own their $250,000 house free and clear. And they live in Texas, which has no income tax.
Thinking about retiring last year, they had kept $400,000 of their $600,000 company 401(k) plan in a balanced fund. The remainder was in company stock. Their intention: Retire, invest all $600,000 in Treasury inflation-protected securities, or TIPS, and do it in a rollover to an individual retirement account. TIPS were earning 2% over inflation.
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Just to be safe, we're going to assume they live to be 100, an improbable event. If both die before that age, their estate will consist of some of their financial assets and their house. If they live to be 100, all they will leave will be their house.
How much money could they spend each year for the rest of their lives? Using ESPlanner financial-planning software, which uses dynamic programming to calculate a level consumption path, I found they would have $35,498 a year to spend on consumption. They would also have $6,500 a year to spend on real-estate taxes and insurance. And they would have enough money to pay their income taxes and their ever-escalating Medicare premiums. Except for the Medicare premiums, which rise much faster, all their expenses are adjusted for a 3% inflation rate. All their spending is in dollars of constant purchasing power.
What if they had waited?
Now, suppose they had waited a few months. Between the broad market decline and a disastrous decline in their company stock, they would've lost $200,000. Talk about bad breaks.But they still could invest the remaining $400,000 in TIPS, then earning 2.8% over inflation.
So how much would their loss have affected their retirement?
Answer: not that much. They'd have $30,232 a year for consumption, $6,500 a year for real-estate taxes and insurance, plus enough money to pay their income taxes and Medicare premiums. So despite losing a full third of their nest egg, nothing would happen to their standard of medical care, nothing would happen to their ability to support their house, and the money they could use for consumption spending would decline by only 15%.
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Why so little?
One reason is obvious: Much of their income comes from Social Security. It softens the impact of lost savings.
But the impact would be reduced for another reason as well: According to Federal Reserve data, while they were losing $200,000, the real return on TIPS was rising from 2% to 2.8%. That extra return would offset some (but not all) of the $200,000 loss. If they were retiring at an earlier age, the loss of income would be still smaller.
Why? Because they'd have more years of higher real income ahead of them to offset the original loss of principal. Basically, the larger the increase in real return and the longer you have to receive that increase, the greater the offset for the loss of wealth.
Continued: From one extreme to another
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