Problems with Constant Compound Interest

This piece is an experiment.  I’m not exactly sure how this will turn out by the time I am done, so if at the end you think I blew it, please break it to me gently.

People in general don’t get compound interest, or exponential processes generally.  It is not as if they are pessimistic, they are not numerate  enough to apply the rule of 72.  (Rule of 72: For interest rates between 3 and 24%, the time it takes to double the money is approximately 72 divided by the interest rate, expressed as a whole number.)

But there is a greater problem, and it applies to the bright as well as the dull.  People don’t understand the limitations of compound interest.

Let me begin with a story: I started my career at Pacific Standard Life, a little life insurer based in Davis, California.  The universal life policieswere crediting 11-12% interest, and annuities were in the 9-10% region.  It was fueled by junk bonds.  One of my first projects was to set the factors that would give us GAAP reserves for the universal life products.  To do this, I was told to project UL account values ahead at 11-12% interest for the life of the policies.

That rate of interest doubles policy account values every six or so years.  What economic environment would it imply to sustain such a rate of interest?

  • High inflation, or
  • High opportunities, because there is little competition.

The former was a possibility, the latter not.  As it was, inflation was receding, and 1986 was the nadir for the 80s.

People buying policies would see these tremendous returns illustrated, and would buy, because they saw an easy retirement in sight.  Alas, constant compound growth rarely happens in economics.  Policyholders ended up very disappointed; Pacific Standard went insolvent in 1989, and the rump was sold off to The Hartford.

Where do we often see constant compound growth modeled in finance?

  • Asset allocation models, including simple illustrations done by financial planners
  • Life insurance sales and accounting
  • Defined benefit pension accounting
  • Long-dated debt obligations
  • Simple stock price models, like the Gordon Model, and all of its dividend discount model cousins.
  • Social finance systems, like public pensions and healthcare.

There are likely many more.  Whenever we talk about long-dated financial obligations, whether assets or liabilities, we need something simple to aid us in decision-making, because the more variables that we toss in, the harder it is for us to make reasonable comparisons.  We need to reduce calculations to single variables of yield, present values, or future retirement incomes.  Our frail minds need simple answers to aid us.

I’m not being a pure critic here, because I need simple answers also.  Knowing the yield of a long debt obligation has some value, though if that yield is high, one should ask what the is likelihood of realizing the value of  the debt.  Similarly, it would be useful to know how likely it is that one would receive a certain income in retirement.

I’m going to hit the publish button now, and pick this up in a day or so.  Until then.