(Maybe a bit less than you think)
We often hear that inflation erodes the value of our savings, and that it's one of the greatest financial risks to a comfortable retirement. And while that’s undoubtedly true in the general sense, how much we should worry about it depends in part on the rate of inflation we anticipate. After all, the Federal Reserve and many other central banks target an inflation rate of 2 percent, not 0 percent. What does that mean in terms of retirement planning?
An Easy Choice?
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, 2 pennies tomorrow, 4 pennies the day after tomorrow, 8 pennies the next day, and so on, for 30 days?
The (Perhaps) Surprising Answer
For most of us, the choice 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 answer illustrates just how much our brains aren't wired to think in terms of long-term compounding, whether of interest or inflation: Had you chosen the one penny today, 2 pennies tomorrow, and so on, 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, and it’s all too easy not to anticipate its longer-term consequences. Much like the myth of the frog in a slowly heating pot of water (actually, the frog would hop out when it got uncomfortable), we may not immediately notice that our dollars aren’t going quite as far as they used to.
What Is Inflation?
Although economists have more technical definitions in terms of the money supply, 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 your 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, which measures the average change over time in the prices for a market basket of goods and services. It provides an approximation of the cost of living.
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 vs. vacation travel), and the choices we make as consumers.
The Rule of 72
An easy rule of thumb to determine how long it will take for your money to double is called the rule of 72. Simply divide 72 by the annual interest rate you’re earning on your money to get a rough estimate of the number of years it will take to double.
Example: Nick earns 3 percent per year on his savings. How many years will it take for his money to double? Dividing 3 into 72 gives us 24, the approximate number of years it will take for Nick to double his money.
Now suppose Nora is making 5 percent on her savings. Her money will double in just over 14 years—10 years sooner than Nick’s.
Unfortunately, the same rule of 72 cuts both ways—dividing the rate of inflation (rather than interest) into 72 also tells us approximately how long it will take for the purchasing power of our savings to be cut in half.
Example: Assume that, instead of receiving interest, Nick is experiencing 3 percent inflation per year, while Nora is experiencing 5 percent inflation. Nick’s savings would go much farther than Nora’s, who would lose half of her purchasing power in just 14 years, vs. 24 years for Nick.
Is 3 Percent a Good Estimate of Future Inflation?
In developing retirement plans, many financial planning professionals have traditionally assumed an average inflation rate of 3 percent over the long term. That’s in line with the 103-year annualized average of just over 3 percent inflation since 1913. (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 are rising faster than the average. These estimates are meant to be reasonable and conservative, helping to ensure that people don’t outlive their money.
Being Too Conservative Just Might Spoil the Fun
Nevertheless, being overly conservative with estimates of future inflation (and, thus, expenses) may potentially lead people to spend less than they might want to earlier in retirement (forgoing that dream trip, for example), or to make decisions (such as downsizing the house) that aren’t necessarily warranted.
And long-term averages such as 3 percent 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, while during the 1970s, inflation compounded at over 7 percent for the decade, reaching a high of more than 13 percent in 1979 alone.
Source: McGovern Financial Advisors, LLC calculation using BLS data.
Long-term Inflation Has Been Trending Downward
To answer the question whether 3 percent 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 real (actual) inflation rates during that time.
Example: Assume that Donna retired at age 65 on January 1, 1968, and lived through December 31, 1992 (25 years). Donna retired into one of the worst decades (in terms of inflation) of the 20th century (the 1970s), and as the chart below indicates, she experienced an annualized rate of inflation of nearly 6 percent over that 25-year period.
Her son Wyatt, on the other hand, retired on January 1, 1992 and lived through December 31, 2016. His annualized rate of inflation over those 25 years was just over 2 percent—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.
Is 2.5 the New 3.0?
The same trend emerges if we simply look back at annualized inflation rates for recent periods going back 30 years. As the table below illustrates, despite the long-term average of about 3 percent, we have not experienced 3 percent inflation for any sustained period in recent memory.
Annualized Rates of Inflation for Recent Periods
Source: McGovern Financial Advisors, LLC calculation using BLS data.
The data and trendline of recent decades, then, 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 percent instead of 3 percent.
So What’s the Big Deal?
While 2.5 percent versus 3 percent inflation may seem to be a small difference, over time the compound effects of this assumption can be large.
Example: Assume that Fred and Barney each keep $1 million under the mattress. Fred experiences 3 percent inflation, while Barney experiences 2.5 percent inflation. After 25 years, Fred's money will be worth just under $478,000 in today's dollars. Barney's, on the other hand, will be worth about $540,000. Barney's purchasing power will be $62,000—13 percent—greater than Fred's.
Even a small difference in the inflation assumption, then, can produce effects that are greatly magnified by time and the power of compounding.
How to Protect Yourself from Inflation, Whatever the Rate
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 demonstrates the importance of investing in asset classes that can protect against, and even out-perform, inflation over the long term. One such investment is 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 (1968 through 1992), with all dividends reinvested, she would have experienced a real rate of annualized return (i.e., above the rate of inflation) over her 25 years of 4.4 percent, despite high inflation rates. Wyatt would have fared even better, with an annualized real rate of return of 6.9 percent.
Even in retirement, then, 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 percent, 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 its risks (and likely magnitude) with a strategically well-diversified portfolio is your best protection in retirement.