Inflation Can Destroy Retirement

6/4/08

Henry K. Hebeler

If you start measuring inflation after the Great Depression, inflation has been 4%, not 3%.  Long periods of recent history had over 6% inflation.  My father retired in 1965.  He lived to 96.  During those years his purchasing power declined 80%!  In the first ten years of my own retirement, my fixed pension lost 30% of its purchasing power--and that was in a time of supposedly low inflation.

Inflation makes retirement planning very difficult.  In ten years, $1 m target today is a $1.34 m target at 3% inflation, $1.5 m target with 4% inflation or $1.8m target with 6% inflation.  With 4% inflation, a 25 year old aiming to be a millionaire would have only $210,000 in today’s dollars on reaching 65.

Real return (return less inflation) is the key to success.  After taking out investment costs, income taxes and the penalties of reverse-dollar-cost-averaging, few retirees are able to do much better than 1% real return.  And that's for buy and hold investors.  Those who chase the market are likely to do far worse.  Morningstar reports that the average investor in mutual funds fails to get most of the return reported by the mutual fund companies—largely because they bought after the price had already gone up and sold after it had already gone down—just the opposite of what they should have been doing.

Lots of financial articles now tout “safe” withdrawal rates varying between 3.5% and 4.5%.  These numbers come from historical statistical simulations to determine how much an early retiree can withdraw from investments to have a high future “success” rate of perhaps 70% to 90%.  (They often fail to cite that the future may not be like the past.)  A "safe" withdrawal rate of 4% early in retirement corresponds to a 0% real return for a 25 year period or 1.2% real return for a 30 year period.

Inflation-adjusted investments should be part of a retiree's portfolio as should some very secure performers.  I don't know whether we are headed for another great depression or hyper inflation or a combination of both, but the costs of supporting these incredible levels of debt have to bring really serious problems for us, our children and grandchildren.  For a number of years now I've been laddering inflation-adjusted immediate annuities and buying I bonds.  This year, the feds really cranked down on I bond purchases.  They went from $30k per person per year to $5k.  Of course you can double the amount by buying $5k at a bank and $5k on treasuriesdirect.gov.

There is now little doubt that inflation for retirees is higher than the CPI.  The huge increases in medical costs combined with the increased need of the elderly for medical care greatly biases the results.  It's like inflation squared for the medical component of a budget.

The feds made a huge mistake forcing us to use alcohol in our gasoline.  It's going to get absolutely horrible in a season with little rainfall.  Ethanol takes more energy to produce than it yields, costs more than gas, requires farm subsidies, and reduces the miles per gallon of our fuel.  All of these things further drive inflation.

Inflation reduces the apparent size of debt.  That’s why we didn’t need to pay back the national debt for so many years.  Inflation was doing it for us.  Similarly, those who had large fixed mortgage payments found that they were easier to pay as they earned ever cheapening dollars.  That doesn’t mean that getting into debt now is a good idea.  Debt is a negative investment, so you still have to be able to earn a larger after-tax return on your investments than the after-tax cost of the debt interest—and that’s really tough in this environment.