Hugh F. Wynn
Beware! The Inflation Monster Can Wreak Havoc on your Retirement
The average inflation rate hops around like a floppy-eared jackrabbit over time, but since the early 1900s America’s inflation has averaged about 3% per annum.
I have mentioned this avaricious old dude in passing, but it is now time to write a blog focused on the devastating impact Izzy the Inflation Monster can have on the long-term health of your retirement portfolio. First, we’ll draw a picture of how a particular rate of inflation can affect your future retirement purchasing power versus how much the same dollars would buy you today. The average inflation rate hops around like a floppy-eared jackrabbit over time, but since the early 1900s America’s inflation has averaged about 3% per annum (In the 1970-1979, it averaged over 7% – during the period 2010-2018, about 1.80%). Two percent or even 3% doesn’t sound like much, but over the long haul, it can gobble up meaningful chunks of your purchasing power in retirement.
Will You be a Millionaire?
In our example, we will assume that beginning at age 22, a wise young investor, hoping to save $1 million before retirement, opens a Roth IRA, uses a Bankrate Investment calculator to determine the amount of monthly savings ($367) needed to reach that goal, routinely invests the $367 in a Total Stock Market Index Fund yielding 6% over time, compounded quarterly, and retires at age 67. Without considering Izzy the Inflation Monster’s impact, after 45 years, the plan produces the desired $1 million. Wow! One million bucks! Is the investor sitting pretty for the next 10-30 year of life in retirement, or what? Maybe, maybe not.
Let’s give the investor credit for the patience and fortitude required to enter the retirement years with $1 million. That’s a lot of scratch. However, using the same data, but allowing for an inflation rate of 3%, let’s determine what the purchasing power of today’s dollars (the $1 million) will actually buy in 45 years. How about $265,000? WHAAAT! That’s right. Izzy is voracious. At a more manageable inflation rate of 2%, the purchasing power would equate to $411,000. Now you know why I call Izzy an Inflation Monster. That old boy will take $1 million and gnaw off huge chunks in terms of purchasing power over time.
What To Do?
To get a better feel (hypothetically) for how to end up with $1 million of purchasing power in 45 years, let us do some reverse engineering. In a 3% inflation environment, you would need to invest $1,385 per month (instead of $367 per month) for 45 years at 6%, compounded quarterly to realized $1 million of actual purchasing power in 2064. In short, you would need to accumulate about $3.78 million over the 45 years to purchase what $1 million would buy you today.
When Bread Cost 28 Cents
Conducting this exercise can be pretty darn discouraging to a potential saver/investor. But remember this. Generally speaking, inflation causes almost everything to adjust upward in price. I say generally speaking because some products actually improve in quality and go down in price (i.e., flat-screen television sets). As the cost of living increases, salaries and other sources of income tend to adjust upward.
Let’s go back 45 years and review a few income and cost numbers. In 1973, the average retail price of gas was $.39, equivalent to $2.31 in 2019; a loaf of bread cost $.28; a gallon of milk, $.53; a car, $3,500; a house, $47,000, and average income hovered around $9,600. Generally speaking, $300 in 1973 would equate to $1,773 today (the annual inflation rate over the period since 1973 approached 3.94%).
My point is simply this. When setting retirement goals (in dollars), DO NOT forget to consider the potential impact of Izzy the Inflation Monster on those goals.
So, how does an investor protect against the ravages of inflation? You’ve probably already guessed what my primary tool would be – diversification. And the easiest way to accomplish that is by building your portfolio around our old friend, an index fund. Tie yourself to the broad market, which (so far) has grown in value over time… a broad-based, built-in inflation adjuster. Other income streams that provide inflation protection include rental property (if you include inflation-adjusted rent provisions in the contact); and Treasury Inflation-Protected Securities (TIPs); or perhaps those Target-Date funds of funds. And consider delaying those annually inflation-adjusted Social Security checks as best you can. The greater Social Security is a percentage of your total income, the greater your protection against inflation. And keep the rate of inflation in mind once you begin taking withdrawals – traditionally 4% per annum from your collective nest egg.
When taking withdrawals from your retirement portfolio, try to preserve those income sources that are blessed with inflation adjusters by drawing down fixed income puddles first. As an example, pull from no- or low-interest-bearing cash reserves first, but be sure to maintain a comfortable “rainy-day fund”. As needed, supplement your cash reserves with maturing bonds. And replace maturing bonds, when possible, with the sale of “surplus” equities in those years when your equities achieve above-average returns.
It is a juggling act but do your best to keep the correct proportion of fixed income to equities – a necessary activity if you hope to outwit and outlast old Izzy. And speaking of social security, which generally adjusts for inflation in most years, let us address an age-old question. Is your Social Security benefit an asset or a bond…or neither? We’ll discuss that in my next blog.
COVID-19: Don't Wait til It's Too Late
Many investors will wait until the pandemic is contained. Many will wait until a vaccine is discovered and distributed. Many will wait until the country goes back to work, reviving our massive economic engine – which will not happen overnight. Waiting…waiting…waiting. Lots and lots of waiting. And just when will you know for certain that these things have happened… will it be before or after the news breaks? Perhaps it is wiser to dollar-cost average your way through these various elements of recovery. In short, be there before the news breaks that these events have happened. If you are not there before the news breaks, odds are, you will miss a sizable portion of the recovery associated with each