Fighting Inflation the Hard Way

Can you live comfortably on half of what you are living on now?  I guess the bigger questions is, would you want to?  That’s the question you have to ask yourself if your retirement plan ignores the effects of inflation.

When you’re figuring out how much money you'll need for retirement, you’ve got to forecast a few inputs that you can’t really predict with certainty.  You won’t really know whether you were right about your predictions until after you’ve gotten to the end, which is a little late for retirement planning.  You’ll need to guess how long you’ll live, what return you’ll make on your investments, and how much you plan on spending over those retirement years.   And spending will include inflation, whether you include it or not.

Life Expectancy 

According to U.S Census Bureau data I can expect to live another 33 years.  That seems a little low to me.  I’m pretty healthy and two of my grandparents lived well beyond 82.  Of course you never know what is going to happen, but I’m planning for 100 birthdays, just to be safe.  The last thing I want to do when I wake up on my 83^rd birthday is have to go look for a job.

Return on Investments

You can’t really know with certainty how much you’re going to earn on your investments either.  Depending on your risk-tolerance and your resulting asset allocation though, history can give you a little bit of guidance.  And when you use William Bengen’s Safemax approach, you’re betting that you will experience the worst historical combination of returns and inflation over your projected time period.  So that should provide some comfort.  Unless of course you think things are going to be even worse.  In which case, you should adjust for that. 

If you’re basing you retirement plan on double-digit expected annual returns though, I’m going to predict that you’re not going to make it to the end with enough.  (Or alternatively that you wind up at Club Fed for insider trading, which of course is another way to take care of your retirement.)

Inflation

And if your plan to beat inflation is simply to shave down expenses each year by the inflation rate, you’d better be prepared to spend only half of what you are spending today. 

The annual inflation rate has been pretty low over the last couple of decades, between 2 and 3%.  Some people think that the Federal Reserve’s current easy monetary policy is going to cause those numbers to skyrocket in the future.  But even in these relatively low inflationary years, the cumulative effect of inflation over the last two decades is almost 82%.  The basket of goods that cost you $100 in 1990 would cost you $182 today.  Because some items are going up faster than other items, your individual basket may vary.   

In my case, health insurance has been going up by double digits each year, and this line item is a pretty hefty chunk of my basket of goods.  My retirement plan assumes a 3.5% inflation rate, which would roughly double my expenses two decades from now.  I can try and combat some of this, sure.  I just bought a car that gets double the gas mileage as the old one, so there, I cut that expense by half.  But 20 years ago gas was about one-quarter what it is today, so after inflation, I’m still behind on that line item. 

As inflation goes up, you can switch from beef to chicken, wine to water, and dining out to dining at home.  You can give up vacationing, concerts, and sporting events.  You can downsize from two cars to one, from four bedrooms to two, or move from California to Kansas.  But what do you do if you already live in Kansas with one car and two bedrooms?  Or what do you do if the things you give up don’t offset the increased cost of health care, long-term care, or things you have to pay others to do because you can’t physically do them anymore?

Even if you can slice and dice to try and whip inflation, the question is, do you really want to bake that reality right into your retirement plan?

Related Posts:

            See Dick and Jane Retire

            See Average Joe Retire

            Building Your Retirement Budget

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Comments

[deegee]

Syd, you should also mention how one's expenses in retirement may be lower compared to when still working because one's mortgage is paid off.

I keep track of my expenses and they are actually lower today than they were in the late 1980s and early 1990s, even after factoring out a new car purchase in 1992 and refinancing the mortgage in 1992. I also exclude income and FICA taxes because they rise and fall as income rises and falls.

Similarly, when I retired in 2008 I saw my commutation expenses disappear (along with those annoying FICA taxes) while my health insurance expenses increased by about the same amount. Thanks to the ACA we retirees will often have our health insurance premims subsidized, osoftening the effect of inflation on that fast rising expense.

[Retired Syd]

deegee: That's a good point. Even with a mortgage my retirement budget was only about three-quarters what my spending was the year before I retired. I made adjustments to the budget in order to make the retirement numbers work, in part with expenses that naturally go down with retirement, but also with some discretionary items.

I could certainly cut further in a pinch, but I'd rather not. This is the level that was the right trade-off for me. Giving up some things to get all the extra time--it was worth those trade-offs to me.

[Jacq]

Shouldn't changing how you invest come into play if you anticipate inflation? Avoid longer term bonds and own commodities and dividend growth investments. There's no reason why an individual can't hedge their life/expense requirements.

I think that most people who retire early - and have saved for that themselves (vs. being on a pension) will be fine in a situation of higher inflation since they're usually pretty in tune with their finances and will probably see how things are changing and adjust accordingly. People with a non-COLA pension may not have had to be that involved with their finances so could end up getting burned.

You and deegee don't have the decrease in kid expenses that occurs as you / they age that is a major cost for most people (not really me so much - unfortunately for my kids I guess). There's one +1 for having kids!! :-)
Well, unless they're like my ex and end up costing their parents more at 45 than they did at 15. Although that's pretty discretionary...

[retirebyforty]

We are already living frugally and I really don't want to cut down our expenses by 50%. I would consider moving oversea though. That's one way to cut down expense and still maintain an acceptable lifestyle. Housing and health care expenses can go down by a big margin if you choose the right location.

[Retired Syd]

Jacq: I agree, you can always invest based on your expectations. I've been in shorter term bonds for the past 5 years, thinking any day now interest rates are going to go up (I've been wrong on that for 5 years though, and earning very piddly returns in exchange.) Chatter in the financial news is warning about a big bond bubble pop right now, which seems about right to me. But even a broken clock is right twice a day.

But the point really wasn't about expecting increased inflation--it was rather on the danger of inflation even at these current very low historic rates of 2-3%. They already have a very strong impact on your long-term retirement plan even at the normal rates that are very much baked into our economy right now.

Another point worth mentioning is that to the extent your retirement expenses are covered by Social Security and/or inflation adjusted pensions, you already have some built in inflation protection. Although there is some talk by politicians of adjusting the annual cost-of-living increase to a new method, Chained CPI, which won't really keep up as well: http://blogs.marketwatch.com/encore/2013/01/16/be-honest-about-the-social-security-cola/

Chances are by the time you retire, your projected budget already reflects the decrease in such expenses as mortgages, retirement savings, taxes, and children. But don't forget that other temptation--spending on the grandchildren!

retirebyforty: That is another option, there are several others too, taking on a part-time job, taking out a reverse mortgage, selling stuff on ebay. I just prefer to have all those options available to me for the unexpected. I'd rather acknowledge inflation's effect at the front end of my retirement plan and use all those "Plan B's" for the unexpected.

[fred doe]

YO! Syd: What's with this glass half empty stuff? If you live to be 80 that's when you want to get that job:) You'll be board out your mind by then and a job will give you people to hang out with? You can regale youthful coworkers with tales of your youthful misadventures ( wait, that's what I do now) I'm planning to be a entrepreneur when I'm 80 making sand sculptures on the beach in Atlantic City (if it's still there?) just lay a blanket out and have the shoe bees pitch me quarters for my work. So in 20 years I want all the right wing libertarians to remember me as they pitch a quarter and say, "now that's the american spirit".

[Cyclesafe]

Interest rates go down, stay the same, or go up. Unless we enter an alternate universe where interest rates are negative, there is only (eventual) downside to, say, mutual fund bond portfolios.

Individual bonds must go down in value too, but they will still pay interest at the contracted rate and full principal at maturity. Staying short term mitigates interest rate risk and is better than holding cash, but yields are overwhelmed by inflation. Yield curve theory nothwithstanding, long term maturities don't counter inflation either.

If one has faith both in capitalism and the future rule of law, investing in the market (long term, diversified, risk-tolerance-balanced) will remain an efficient means of managing inflation’s impact. I have statistically 26 and optimistically 42 years left; I am allocated 5% cash, 10% home equity, 15% staggered maturity 3-year CD's, and 70% well-diversified equity; and I consider my exposure to interest rate, inflation, and systemic risk to be throughly acceptable.

If capitalism implodes and/or bandits prevail, then the bureau's statistics and my optimism will yield in the ensuing apocalypse. And I’d probably regret not stockpiling assault rifles.

[Retired Syd]

Cyclesafe: Exactly. Couldn't have said it better myself.

[Retired Syd]

Cyclesafe: Your comment just put something together for me. Some people find having any money in the market too stressful. So they may accept the lower returns of bonds, CD's, cash but will either have to start out with a larger nest egg or accept a lot of budget cuts down the road as inflation eats away at their purchasing power.

I guess I found that alternative too stressful--either working longer to amass that larger nest egg of "safe" assets or the alternative of constantly downsizing for the next 50 years.

[Retired Syd]

Jacq: Sometimes I read comments too fast. The part you mentioned about investing in bonds, dividend growth stocks, and commodities--I would say that retiree is taking inflation into consideration. Or at least it's the way I deal with it--having at least 50% of my assets allocated to equities so that the impacts of inflation are hopefully covered by my returns. Instead of coming out of my annual budget. Sorry I missed that the first time through.

[Jacq]

Oh no problem. I'm an O&G bug just because it's the devil I know and the industry I've worked in for a long time. I was in a bond fund for all of 2 minutes (ok, maybe a month) before I realized I knew nothing about that kind of investing - but "everyone" said you had to have some kind of 60/40 type of allocation and I thought that I should do that too. It was a mistake at the time since I missed a good run in *my* commodity.

I've gone variable on my mortgage the last 4 years because I haven't seen the fundamentals yet behind an interest rate hike and I don't see it now. If I see it start to happen, I'll definitely be making some changes. Maybe pay it off / down since it's pretty small. I just recently cut down my over-payment to the mortgage because it just didn't make financial sense (not arguing that for some the emotional payoff is worth it.)

To be honest, I am hoping for inflation to rear it's ugly head. I'm hedged up the ying yang and it would be some great icing on the cake. Feels kind of mean to be saying that though.

[Cyclesafe]

The market will go back up. If you hold cash, inflation is forever...

[Retired Syd]

Jacq: That's funny about the mortgage. I have a variable that is at 2.875% for another year. I know that's a great deal, but I think I'm going to pay off the balance soon. Makes no financial sense, I know. It's all emotional.

[Jacq]

Syd, I have a friend that's ER-ing that laughs at me because I always pre/over-pay utilities. It's all emotional - that I see the CREDIT BALANCE - DO NOT PAY on the bill when I open it and I get the warm and fuzzies. There comes a point I think when certain bills just become annoying and you don't have to worry about the "opportunity cost" of it, and the mortgage is probably one of them. For all that we think about money, I think sometimes the goal is not to have to think about it at all. That's a good place to be.
Sort of like ER, you're not thinking about how much money you're foregoing, but whether you *want* to work or not. Or whether you *want* to see a monthly withdrawal for your mortgage on your bank account or not. The ability to choose (and even make a financial "less wise decision") is a good thing.

[tom sightings]

Good post. Inflation hasn't been much of a problem for the last ten years or so (except for health-care costs), but for those of us who hope to be around for another 20 or 30 years, it will almost inevitably come around again at some point, and so we need to be prepared.

[Elderly Care Miami]

Great post. Thanks for scaring me a little. Though its not new, reading things again does get you thinking more. Retirement changes one's lifestyle, unless you have lots of gold in your bank. Coping up with inflation is the most important thing. Well in times saving a penny will also be important.