The Real Rule of 72
“In this world nothing can be said to be certain, except death and taxes.”
Benjamin Franklin was mostly right.
He did leave out a few of life’s other certainties. While one could add a number of things to this list, let’s avoid a philosophical tangent and stick to just one – one that could be quite impactful to your clients’ financial goals:
If history is any indication, it seems we could consider inflation to be another of life’s certainties – especially in the long run. As measured by the Consumer Price Index (CPI), the cost of goods in the United States has more than doubled in the past 30 years, and has seen more than a 22-fold increase in the past century.
Now let’s talk about the Rule of 72, a simple formula your clients may have been exposed to that most advisors are familiar with: divide 72 by your expected investment return and the result indicates the number of years you should expect it to take for your investment to double. For example, let’s say I’ve seen an 8% return in my Roth IRA over the past 5 years and I expect that to continue. I divide 8 into 72 and I come to you, my advisor, with the expectation that my money (and by extension and assumption the future value of my money) will double every 9 years (72 ÷ 8 = 9).
Since I’m 30-years-old, have $100,000 saved in my account, and plan to retire at age 66, I should expect my investment to double four times over the next 36 years (36 ÷ 9 = 4), setting me up to have about $1.6 million ($100k x 24 = $100k x 16 = $1.6 million) by the time I retire – right?
What the rule of 72 isn’t accounting for is that inflation could cause the purchasing power of my money to diminish in front of my eyes, even as the total balance grows. Even if my hypothetical 8% return continues, my $1.6 million might only buy a fraction of what I think it will.
Dinner and a movie is now just dinner.
A new luxury SUV is now a hand-me-down hatchback.
A trip to Paris, France is now a trip to Paris, Texas.
Of course, if these are just discretionary expenses, clients will likely find a way to adjust their spending. But what about more basic needs such as health care, housing expenses, and transportation costs? These will all rise in cost with inflation, albeit at different rates.
Let’s go back to my earlier example and say I invest $100,000 at age 30 and watch it grow at 8% a year for 36 years. At age 66, my $100,000 has grown $1.6 million as expected. However, if we assume an inflation rate of 2.7% (which Russell currently forecasts over the next 20 years), my nest egg will have lost more than half of its purchasing power!
$1.6 million in 2051 will buy the equivalent of what approximately $600,000 could buy today. So in this case, the Rule of 72 is really the Rule of 112 – as adjusting for inflation means it will take 14 years for 8% to effectively double my purchasing power (112 ÷ 8 = 14).
Consider the following chart, illustrating the effect of inflation on purchasing power:
That’s a painful reality I, as an investor, wasn’t prepared for. Many investors are likely to find themselves in the same boat if their assumptions are primarily rooted in the overly simplistic and ultimately flawed ‘Rule of 72.’
OK, so now what? Another popular saying: the best defense is a good offense.
Reach out to clients and help them understand the reality of the ‘Rule of 72.’ Leverage this post to remind them about the risks of putting too much stock (pun-intended) in general rules of thumb, like the Rule of 72, by illustrating the actual impact of inflation on long-term investing. Though it’s not included in this particular post, remember to include the impact of taxes on wealth accumulation – another reality that investors often overlook.
“Expectation Manager” is one of the most important roles you can play. Though the comprehension of this concept may conjure pain and frustration for clients, you have the opportunity to strengthen their confidence in their financial preparedness.
Clarity is a powerful motivator.
Maybe clients will realize they need to save more to achieve their goals, or maybe they’ll be compelled to define a new and more appropriate set of “inflation-adjusted” goals.
Either way, they’ll have a more realistic view of their financial future, and they’ll thank you when they aren’t surprised by the impact of inflation and are well prepared to enjoy their golden years.
Copyright © Russell Investments 2015. All rights reserved.Russell Financial Services, Inc., member FINRA, part of Russell Investments.