Inflation is that unpredictable economic factor that makes people say, “I remember when you could buy a candy bar for a nickel.” Of course, the question to ask in response is, “What were you earning a week then?” Chances are they were earning between $35 and $50 a week. Today that same candy bar is now a dollar or more and salaries have increased to hundreds of dollars a week. The rising costs of goods as a result of inflation are matched with rising salaries.
When we are working, we expect that in addition to salary adjustments in reward for good service, we will receive an adjustment due to the cost of living. Because salaries adjust to reflect changing rates of inflation, we often don’t consider inflation as a key factor in retirement planning.
Many people understand that inflation is important, but don’t know how to assess its impact. Failure to understand and plan for the effects of inflation can lead to planning mistakes and a lasting negative impact on your retirement lifestyle and your estate value. For planning purposes, you should recognize inflation in two basic ways, general and specific.
General inflation converts the nominal, or face, rate of return you receive from your investments into a real rate of return. For example, if you invest $100 for a year and earn a 10 percent return, you’ll have $10 more to spend than you started with. But, if, during the course of that same year, the price of that new paperweight you had your eye on rose from $10.00 to $10.30 — a 3 percent inflationary increase — your $10 return is no longer enough to cover the cost. The value of your investment return has been reduced by the rate of inflation. A 10 percent nominal rate of return reduced by inflation of 3 percent produces a real rate of return of only 7 percent.
This example is important because realizing a 7 percent rate of return over 30 years when you were planning on a 10 percent rate could mean running out of money far ahead of schedule.
The good news, though, is that real rates of return — the difference between long-term rates of return for various types of investment assets like stocks and bonds and the rate of inflation — has been more predictable during the past 100 years than the nominal rates of return or rates of inflation.
This makes sense because as inflation rises and falls, so tend the rates of returns demanded from and produced by various investments. We were able to see this in the 1980s when there were double-digit inflation rates and CD yields.
If you plan using real rates of return, rather than the more commonly used nominal rates, you can ignore the general rate of inflation and think of everything in today’s dollars.
n my work with clients, I find that they become concerned when trying to account for inflation in their spending needs. When I ask how much they will need to spend on a certain category of goods, such as groceries, in retirement, they’ll have trouble answering because they’re not sure what the item will cost five, 10 or 20 years from now. If I help them plan using the real rate of return — the expected growth rate for their portfolio minus the expected rate of inflation — they can just estimate their future spending needs using today’s dollars. If they’d need $50,000 per year to spend if they retired today, then this is the number they can use throughout the planning period without having to adjust further for inflation.
Financial planning becomes more complicated when the rate of inflation affecting a particular factor — a specific rate of inflation — is expected to be higher or lower than the general rate of inflation. Both education and health care costs are good examples. The costs associated with these planning factors are expected to rise at rates significantly higher than the general rate of inflation through the near future.
The effects from these differential inflation rates are not accounted for by the reduction to nominal rates of return corresponding to the general rate of inflation. If, as in the example above, you plan using a real rate of return of 7 percent — 10 percent nominal return less 3 percent general inflation — but expect significant education expenses that rise 7 percent per year, you’re likely to come up short in your tuition fund. This is because the real rate of return you’ll be earning on your education fund investment will only be 10 percent minus 7 percent, or 3 percent per year.
Additionally, specific inflation rates must be accounted for either by detailed cash flow analysis or by further adjustment to the real rate of return. This is specifically relevant for federal retirees in the case of annuity income.
CSRS, FERS adjustments
It is reasonable to assume that both the Civil Service Retirement System annuity and your Social Security retirement income will be adjusted with the general rate of inflation. As a result, no further adjustment for planning is necessary. However, anyone with a Federal Employees Retirement System component to their annuity should make sure that their planning and analysis has accounted for its lower rate of inflation adjustment. If you plan using a 3 percent inflation rate, but your FERS annuity income will only inflate at 2 percent, then this retirement income stream will become less valuable over time. This typically leads to an increasing reliance on other resources — usually savings — to support spending needs. This effectively lowers the real rate of return on the resources used to support this spending by 1 percent.
Additionally, federal employees should always make certain that analysis for such proposals as “pension max” — the replacement of an annuity survivor benefit with life insurance — accounts for the effects of inflation before signing on the dotted line.
The math and analytic techniques that include inflation in retirement planning can be complex and intimidating. Very few do-it-yourself planners and surprisingly few professional “financial advisers” are up to the task. Nonetheless, it is critical.
Written by Mike Miles
For the Federal Times
Publication January 29, 2007