By Brad Thomason, CPA
One of the things that gets in the way of having easy conversations about retirement planning is that many of the most important variables are important, not for their effect in a given year, but because of the cumulative effects that pile up as the years go by.
Cumulative effect is difficult (to impossible) to track using the kind of mental math tricks we use for calculating how much we should earn in a year from a particular rate of return, or how much money we need to put in the bank to cover the checks we’re about to write. Cumulative implies several, over time, which in turn means lots of calculations. It’s just too easy to get lost – quickly – if you try to track that sort of thing in your head; and instinctively we usually avoid even trying .
This, in turn, leads to an unnerving situation in which the thing that seems to be the obvious choice may be the exact opposite of what you ought to do; and what you ought to do, first pass, makes absolutely no sense.
An investment of $100,000 will earn $7,500 next year if the rate of return is 7.5%. It will earn $500 more if the rate is instead, 8%. Five hundred bucks isn’t a lot of money.
But if you let that difference ride and compound for twenty years in a tax-deferred environment, the cumulative difference is over forty thousand dollars. Which sort of is a lot of money, especially relative to where we started.
We’ve modeled real estate investment deals before where we put in assumptions like “no net income for the first five years” and still had the project be an obvious green-light when viewed from the perspective of a fifteen or twenty year holding period.
How? Such a deal commonly has multiple places where cumulative effect can creep into the equation: the pay down of the mortgage reduces future interest charges; once money is reserved for repairs and maintenance we may get to allocate more to income or debt reduction in future years; the longer the holding period, the more rent checks we get (like selling a product, the more times someone pays to use your property for a month, the more your sales tally goes up). Notice that I didn’t even mention things like rent increases or property appreciation. Or the option of using the earnings from early projects to fund additional projects in the future, increasing the total amount of productive capacity in operation.
All of these things are essentially impossible to see if all you look at is cost to acquire and monthly rent potential (in this particular case). Nor are the effects particularly noteworthy in any given period. But what they accumulate to in the end certainly may be.
When the topic is retirement (an exercise in trying to envision what several decades might look like) small changes in rate of return, inflation assumptions, the timing of medical expenses and a long list of other things can and will affect the results in ways that almost always seem out of proportion to the change itself. It’s just the way it is.
That’s why it’s so important to engage in more than surface level thought. The way things appear on the surface is frequently not indicative of the true effect that they may have over time. What seems like a good idea may be a bad one; and at times you may find yourself wondering why on earth anyone would consider some action which seems to obviously be wrong, and yet, isn’t. You can be fooled either way.
The only way I know to not get fooled is to take the time to be thorough. Which won’t guarantee you a favorable outcome, by the way. But one of the implications of living in a world where big cumulative effects can come from small inputs, is that it can work in your favor, too. You don’t have to avoid walking into too many mistakes before it starts to have a positive effect. So even if you can’t catch them all, nor get guarantees of how random events will unfold, catching even some of the avoidable ones can make a big difference. Which makes it worth the effort.
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