By Gene McGovern, MBA
In the context of retirement planning, it’s common to read that inflation erodes the value of our savings and that it's one of the greatest financial risks to your retirement goals. While this is undoubtedly true in the most general sense, how much of a threat it poses depends greatly on the rate of inflation we experience.
The Federal Reserve and many other central banks target an inflation rate of 2%, not zero percent. What does that mean in terms of retirement planning? To illustrate the power (and potential threat) of inflation, consider this question: If given the choice, would you rather receive $5 million today or one penny today, two pennies tomorrow, four pennies the day after tomorrow, eight pennies the next day and so on, for 30 days?
The Surprising Answer
For most of us, the choice at first seems intuitively obvious, take the $5 million dollars today. After all, how much could a bunch of pennies add up to even after 30 days? The mathematical answer shows just how much our brains aren’t wired to think in terms of long-term compounding, whether in interest or inflation. (For related reading, see: Inflation and Your Retirement.)
Had you chosen the one penny today option, you would receive $5,368,709 on day 30 alone, and a total of $10,737,418 over the 30 days. As the example illustrates, if we think of the pennies as representing prices doubling every day, even severe inflation's day-to-day effects can often seem small initially. It's all too easy not to anticipate its longer-term consequences because we may not immediately notice that our dollars aren't going quite as far as they used to.
What Is Inflation?
We generally think of inflation as the sustained increase over time in the prices for goods and services that we purchase. Another way to think of inflation is the fall in value of our money: As the prices of things rise, we can’t afford to buy as many of them because the purchasing power of our dollars falls. Conversely, when deflation occurs, prices fall and purchasing power rises.
A broad measure of inflation is published each month by the Bureau of Labor Statistics (BLS), the Consumer Price Index for All Urban Consumers (CPI-U). It measures the average change over time in the prices for a market basket of goods and services. The CPI-U provides an approximation of the cost of living for about 88% of the U.S. population by covering nearly all residents of urban or metropolitan areas.
Each of us, however, experiences a personal rate of inflation rather than an average. The rate we experience individually depends on a host of things, such as where we live, our age, whether we have children, the kinds of things we purchase (for example, spending on health care versus vacation travel, or goods versus services), and the choices we make as consumers.
Is 3% a Good Estimate of Future Inflation?
In developing retirement plans, many financial planning professionals have traditionally assumed an average inflation rate of 3% over the long term. That’s in line with the 104-year annualized average of just over 3% inflation from 1913 through the year 2017. Why 1913? That’s when the BLS began keeping records.
Some planners then tweak that assumption higher to account for the higher rate of inflation for costs affecting the elderly, such as health care and housing, or they may separate out certain individual components, such as college costs, which historically have risen faster than the average. These estimates are meant to be reasonable and conservative, helping to ensure that people reach their goals and don’t outlive their money.
Nevertheless, being overly conservative with estimates of future inflation (that is, estimating a higher rate of inflation than may be justified) could potentially lead people to spend less than they might want to in the early years of their retirement, diminishing their enjoyment, or to make decisions such as downsizing the house that may not necessarily be warranted. Long-term averages such as 3% inflation mask a lot of variability along the way.
As the table below illustrates, during the 1920s and 1930s the country experienced long periods of deflation. During the 1970s, inflation compounded at over 7% for the decade, reaching a high of more than 13% in 1979 alone.
Inflation Has Been Trending Downward for Decades
To answer the question whether 3% is a reasonable future estimate, it’s helpful to look at the compound inflation rate over recent 25-year periods (an average length of retirement) for two hypothetical retirees, Donna and her son Wyatt, using actual inflation rates during those periods. (For related reading, see: How Inflation Eats Away at Your Retirement.)
Assume that Donna retired at age 65 on December 31, 1968, and lived through December 31, 1993 (25 years). Donna retired into one of the worst decades, in terms of inflation, of the 20th century (the 1970s). As the chart below indicates, she experienced an annualized rate of inflation of about 5.8% over that 25-year period. Her son Wyatt, on the other hand, retired on December 31, 1992 and lived through December 31, 2017. His annualized rate of inflation over those 25 years was 2.2% - far less than the rate Donna experienced.
As Wyatt’s experience and the chart above indicate, more recent retirees have experienced a long-term downward trend in the rate of inflation. In only three of the 25 rolling retirement periods since 1969 did the long-term inflation rate tick up rather than down. And in each case, the tick upwards was less than one-tenth of 1%. In all other cases, annualized inflation trended down over each subsequent 25-year retirement period.
The same trend emerges if we simply look back at annualized inflation rates for recent periods going back 35 years. As the table below illustrates, despite the long-term average since 1913 of about 3%, we have not experienced 3% inflation for any sustained period in recent memory.
Of course, inflation in any single year can spike. The annual rate was 4.1% as recently as 2007, and 3% in 2011. Nevertheless, the data and trendlines in recent decades - combined with macroeconomic trends such as globalization and technology disruptions such as online shopping and its price transparency - would suggest that a more realistic and still reasonably conservative long-term average for inflation, at least for the next decade or two, may be roughly 2.5% instead of 3%.
Can Half a Percent Make a Difference?
While 2.5% versus 3% inflation may seem like a small difference, over time the compound effects of this assumption can be large.
Example: Assume that Frank retires and experiences an average of 3% compound inflation over 25 years. Jane, on the other hand, also retires but her annualized inflation rate over 25 years is only 2.5%. Each starts with a portfolio of $1 million. For simplicity, we’ll ignore any investment returns, taxes or withdrawals and assume the same inflation rate each year. After 25 years, Frank’s money will be worth only $477,606 in purchasing power. Jane’s, on the other hand, will be worth $539,391, or $61,785 more. Jane’s money will buy 13% more goods and services than Frank’s.
After 30 years she’ll have 16% more purchasing power than Frank, although note that both will have less than half their original purchasing power. Even a small difference in assumptions can produce large financial effects when magnified by time and the power of compounding.
How to Protect Yourself from Inflation
While long-term inflation has been trending downward and current expectations for future inflation remain somewhat muted, Donna’s unexpected and long-term experience of high inflation in the earlier example of a 1969 retiree demonstrates the importance of investing in asset classes that can protect against, and even out-perform, inflation over the long term. One such investment traditionally has been stocks. Historically, over long periods U.S. domestic stocks have outpaced inflation.
Example: If Donna’s retirement nest egg had been 100% invested in the S&P 500 throughout her retirement (1969 through 1993), with all dividends reinvested, she would have experienced a real (net of inflation) annualized rate of return over her 25 years of about 4.2% before expenses, despite high inflation rates. Wyatt would have fared even better, with an annualized real rate of return of about 7.2%. Even in retirement, when most investors may want to be more conservative, at least some allocation to stocks in the portfolio should be considered in order to keep pace with (and stay ahead of) inflation.
Another type of investment that can protect against the effects of long-term inflation is Treasury Inflation-Protected Securities (TIPS). The principal of TIPS increases with inflation. In other words on a $1,000 TIPS, if inflation for the year is 5%, the TIPS principal amount is increased to $1,050.
When a TIPS matures, the holder receives the inflation-adjusted principal in addition to the stated interest payments along the way. Bonds, gold and other precious metals, real estate, commodities and other asset classes (including international assets) may also outpace inflation during certain periods.
In any event, some degree of inflation will always be with us. Being cognizant of both its risks and its likely magnitude with a strategically well-diversified portfolio is your best protection in retirement. (For more, see: Your Retirement vs. Inflation.)
This article was originally published on Investopedia.