The Inflation Factor

The Inflation Factor

Doug Short is a retired IT manager and lifelong investor with a Duke Ph.D. and a prior career as an English Professor at North Carolina State University.

In the mid-’80s I was seduced by IBM microcomputer technology and spent many years with Big Blue before finally settling on IT management in a Big Pharma company, retiring in 2006. In recent years I’ve formally studied personal finance at the College of Financial Planning.

My main focus is market history and pro-bono retirement planning for busted boomers. Also, having raised my children during the stagflation of the ’70s, I’ve been a devoted student of inflation ever since.

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As a high-school student in the ’60s I filled my ’57 Ford with the cheapest gas I could find: 29.9 cents a gallon. Today I’m paying over ten times as much. Blame it on inflation!

Gasoline is a worst-case example, but consider: Since the end of World War II, inflation has averaged 4.1%, and a dollar’s worth of purchasing power has shrunk to less than 9 cents. This sounds scary, but most working people aren’t greatly impacted by inflation because wages tend to follow suit. However, for retirees on fixed incomes, protecting against inflation requires some planning and vigilance.

The Household Financial Life Cycle

Household Life Cycle - with and without inflation No Inflation: To understand the impact of inflation, let’s imagine a hypothetical household in an inflation-free world. We’ll use the example of a young couple who start working at the age of 22, take out a mortgage for their dream home at age 30, retire at 65, and pass peacefully away at 95. Their starting salaries total $20,000 and double over the course of their earning years. They reduce their expenditures after the house is paid off, and retire on 75% of their final salaries.

4% Inflation: Now have a look at the same household, but this time with 4% annual inflation added to earnings and expenses. Quite a difference! A comparison of these two charts clarifies many things. For example, inflation is the main reason why a long-term fixed expense like a mortgage payment goes from a major burden to a minor nuisance (unless, of course, you upscale your home every few years!). But for now, let’s focus on that mountain of income required after retirement. In this 73-year household life cycle, a 4% inflation rate means that 57% of the total household income is required after retirement. Think about that for a moment. Even with a 25% income reduction at retirement, this household needs more money during their 30-year retirement than during their 43 working years — a period that traditionally includes mortgage payments, child rearing, and college expenses.

Inflation and Retirement Funding

Historical Inflation over 30-year periodsOver short periods of time, inflation can fluctuate dramatically, but when measured over 30-year periods — the typical planning horizon for an individual’s retirement — the variance has been about 2%, ranging from a low of 3.43% for people retiring in the late ’40s to 5.44% for new retirees in the mid ’60s. The average for all of 30-year periods since 1946 is 4.75%, which is a bit higher than the 4.1% average over the last 60 years. The actual erosion of purchasing power during any one of these periods depended on its unique sequence of inflation. High inflation in the earlier years is more erosive than high inflation later in the cycle. The last column in the Historic Inflation Table shows the value of a dollar at the end of each 30-year period. The least impact, a 62% reduction, was felt by someone who retired in 1948; an original dollar shrank to 38 cents. Hardest hit were the retirees of the 60’s, who saw an 81% decline in the value of a dollar hidden under the mattress for 30 years.

As for funding these years, financial planners sometimes refer to the “three-legged stool” of retirement support: Social Security, pensions, and personal savings. Let’s briefly consider how inflation impacts each of these income sources:

Social Security: Since 1975 Social Security payments have increased annually with a “cost of living adjustment” (COLA) tied to the Consumer Price Index for Urban Consumers (CPI-U). Concerns about the solvency of the Social Security system have raised doubts about future support for COLAs at this rate. However, many experts expect shortfalls to be addressed at least initially by social security tax increases and raising the age of eligibility rather than by benefit cuts.

Private Pensions: These usually do not include a COLA, or if they do, the adjustment may be at a reduced rate. In recent years, many companies have discontinued private pensions, in favor of a defined benefit (a.k.a. cash balance) offering. In such cases, the retiring employee may elect to take a lump-sum payout or to establish an annuity. Like the traditional private pension, annuities typically lack a COLA, or if they do have one, the annuity payments are substantially reduced to allow for future inflation adjustments.

Personal Savings: Financial planners commonly recommend an initial withdrawal of 4% or less from personal savings with subsequent annual withdrawals adjusted for inflation. The reason for starting with such a modest rate is partly driven by the need for inflation headroom.

Forewarned is Forearmed

Fixed pension and inflationAnyone approaching retirement with a pension in the mix should find out if it includes a COLA and if so at what rate. Retirees with fixed pensions will see their purchasing power shrink over time: the larger the initial ratio of pension to other income sources, the greater the shrinkage. At 4% inflation, a household with half its income from a fixed pension would see annual shrinkage of 16% by year 10, 27% by year 20 and 35% by year 30. The shrinkage might be tolerable during early retirement, but later, when the odds of increased medical costs are highest, the reduced income could prove catastrophic.

If you have a fixed pension in your future, you should consider two inflation strategies during the retirement years:

  • Continue saving. Those with large fixed pensions should continue saving a part of their retirement income to fund a nest egg for later years when the impact of inflation would otherwise compromise the standard of living.
  • Reduce nest egg withdrawals. Those with small fixed pensions and large personal savings should consider reducing their early retirement nest egg withdrawals to allow accelerating inflation adjustments in later years to offset shrinking pension income.

The optimum savings and withdrawal rates for these strategies will vary widely depending on the ratio of pension to other income sources, the estimated length of retirement, and the required living expenses. Many web retirement calculators include inputs that will assist in the decision process, including the excellent calculator available in the recent RYR Webinar, “How to Plan the Perfect Retirement.”

Portfolio Growth and Inflation

The conventional wisdom for retirees has been to reduce their exposure to stocks and sock away the largest part of their nest eggs in “safe” fixed-income investments: high-grade bonds, CDs, etc. The problem with this advice is that it takes a dangerously narrow view of risk, targeting volatility — the temporary loss of capital. In contrast the risk of inflation is pervasive, and it’s not temporary. A portfolio weighted in stocks will see down years — on average about one in three. But over the last century US markets have trended up at an annualized rate of 10-11%, which is about 6% above inflation over the same period. To build a retirement nest egg, people need portfolio growth that comfortably exceeds inflation. This is equally true for a retiree with the prospect of 30 or more years of retirement. Less stock exposure than 60:40 ratio of equities-to-fixed will reduce volatility, but it also increases inflation risk — the nightmare of outliving your savings.

A good way to “sanity-check” your retirement asset allocation is to calculate the equities-to-fixed ratio you’d have if you held five years worth of expenses in fixed instruments and the rest in stocks. Thus, someone with a $1 Million portfolio who needs an average of $40,000 from savings annually for the next five years ($200,000) would target an asset allocation of 80% stocks to 20% fixed. The beauty of this approach is that it will naturally signal changes to the allocation ratio as the five-year savings pot grows with inflation adjustments and the overall nest egg is reduced by withdrawals. The volatility of an initial 80:20 retirement ratio may be too unsettling for some retirees. For such people a 75:25, 70:30, or 65:35 ratio would provide increased stability while still offering more protection against inflation than the conventional retirement allocations that favor 50:50 or less in equities.

TIPS to the Rescue?

One hedge against inflation would be to weight the portfolio with Treasury Inflation-Protected Securities (TIPS). These pay a fixed rate of interest, on top of which the principal is adjusted twice a year for inflation. Sounds great, but they’re not foolproof. When inflation is rising, TIPS are a sure bet, although the return above inflation is modest. However, when inflation declines, TIPS will prove disappointing. They are probably best viewed as a means of providing diversification within a fixed-income allocation. TIPS will mainly appeal to conservative investors, especially pessimists who see equities as fundamentally overvalued and the economy as destined for years of stagflation.

The Foolish Bottom Line

We can’t control inflation, and we can’t predict the length of our retirement. But we can protect against the erosive effect of inflation with some important steps:

  • If your retirement funding includes a pension, find out if it includes a COLA and if it does, determine how it’s calculated.
  • If you have a fixed pension or one with a reduced COLA, develop a strategy to offset pension shrinkage either by continuing to save in early retirement or by adjusting your nest-egg withdrawals — or a combination of the two.
  • Analyze the asset allocation of your nest egg. Do you have enough stock mutual funds and individual equities in the mix to provide long-term growth that exceeds inflation by a few percentage points?

Like it or not, inflation is an unwelcome guest in your financial household. But with some planning and vigilance, you can make sure it won’t eat your retirement lunch.

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