the Income EffectWhile we are being regaled with unending reports on lost wealth, let's play Pollyanna and examine another aspect -- the unrecognized and offsetting gain in income.

Let's examine what the market crash does to the lifetime income of a couple that retired this year. With a market decline of more than one-third, a few months would appear to make a gigantic difference.

As you will soon see, it doesn't.

The world doesn't end. 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, a state that has no income tax. Thinking about retiring this year, they kept $400,000 of their $600,000 company 401(k) plan in a balanced fund. The remainder was in company stock. Their intention: Invest all $600,000 in secure TIPS, Treasury Inflation-Protected Securities, retire early this year, and do it in an IRA rollover. TIPS were earning 2 percent over inflation.

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 be some of their financial assets and their house. If they live to be 100, all they will leave will be their house.

How much would they have to 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 that they would have $35,498 a year to spend on consumption. They would also have another $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 percent inflation rate. All their spending is in dollars of constant purchasing power.

Now, suppose they had waited a few months. Between the broad market decline and a disastrous decline in their company stock, they lost $200,000.

Talk about bad breaks.

But they still invest the remaining $400,000 in TIPS, now earning 2.8 percent over inflation.

So how much will their loss affect their retirement?

Answer: Not that much. They'll 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 in spite of losing a full third of their nest egg, nothing has happened to their standard of medical care, nothing has happened to their ability to support their house, and the money they can use for consumption spending has declined by only 15 percent.

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 is 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 percent to 2.8 percent. That extra return works to 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.

You can see this most clearly by considering two extremes, the very old and the very young.

The very old have suffered an unrecoverable loss of wealth. The value of their assets is down, and they don't have the time for higher income to offset the loss.

The young, however, may enjoy a lifetime increase in consumption. First, they'll be able to buy a house at a lower price and spend less of their income financing the purchase. Second, like the Tipmans, they may enjoy higher earnings on their investments, but they'll have many more years of higher returns. More important, since they're starting with less in savings, the higher real return will offset any losses faster.

Don't get me wrong. I'm not arguing that everything is hunky-dory. But for many, it may not be as grim as it looks.

ON THE WEB

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