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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. At the peak of the 2005 hurricane season, I was 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 4.12%, and a dollar's worth of purchasing power has shrunk to 8.3 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
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, especially that mountain of income required after retirement! For this 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 a 30-year retirement than during their 43 working years, a period that would have included mortgage payments, child rearing, and college expenses.
Inflation and Retirement Funding
Financial planners sometimes refer to the "three-legged stool" of retirement support: Social Security, pensions, and personal savings.
Social Security: Since 1975 Social Security payments have kept pace with inflation by means of a "cost of living adjustment" (COLA) tied to the Consumer Price Index (CPI).
Private Pensions: These rarely include a COLA, or if they do, the adjustment may be less than the actual inflation rate.
Personal Savings: The degree to which personal track inflation depends entirely on the asset allocation and withdrawal strategies. Nest eggs need enough stock allocation to grow faster than inflation, and withdrawal strategies need enough restraint to ensure the funds aren't depleted prematurely.
Forewarned is Forearmed
Anyone 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.
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 definition of risk, equating it to volatility -- the temporary loss of capital. In contrast the risk of inflation is inevitable, 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 grown at an annualized rate of 10-11%, which is about 6% above inflation over the same period. To build a retirement nest egg, a person needs 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 equities-to-fixed will reduce volatility, but it also increases inflation risk -- the nightmare of outliving your savings.
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:
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