How Inflation Affects Your Retirement Plan
What is Inflation?
Inflation is defined as a sustained increase in the cost of goods and services. Almost all goods and services increase in value over time, regardless of demand or the value of a currency. Most people understand inflation in terms of what they pay for an item now compared to what they paid for it years ago. For example, people in their 70s and 80s paid more for their current car than they did for their first house. People in their 50s paid more for one year of a child's college tuition than they paid for four years of their own.
Inflation happens naturally as the government prints more money and issues more bonds, and businesses slowly raise prices over time. But it can also happen because too many dollars are chasing too few goods and services. This is basic supply and demand. The higher demand becomes, the lower supplies become, which results in an increase. A rise in prices can also happen when a currency loses its strength. This is particularly obvious with the case of oil and gasoline. Barrels of oil are denominated in US dollars. That means in order to buy and sell oil around the world, each country must first convert its currency to dollars. As the dollar loses strength against other currencies due to a weak economy, high debt, and high unemployment, it takes more dollars to buy other currencies, goods, and services.
The core inflation rate is a measure of inflation that excludes volatile items like food and energy. While it may make sense from an economic and political standpoint to leave food and energy out of the core rate, consumers often find it misleading. Even if prices of other goods and services like tennis shoes and haircuts aren't increasing, the cost of a gallon of gas, gallon of milk, cereal, fruit, and other food products are rising every month.
Inflation is the most difficult part of retirement planning to adjust for. A retiree who saves and plans based on an average inflation rate of 3% may run out of money very quickly if energy, food, and healthcare costs increase at 5%, 8%, or even 10% per year. While it's not likely that the US economy will sustain a 10% annual inflation for long periods of time, over the 40 years of an individual's working lifetime, one or two periods of high inflation are likely to occur and must be planned for.
Why Does Inflation Decrease Purchasing Power?
Inflation erodes purchasing power because it decreases the value of a currency. If the rate of inflation is 3% this year, it will take $1.03 next year to buy the item that cost $1.00 this year. While that may not seem like a big deal, over a retirement that lasts 10, 15, 20, or more years, it's a tremendous amount of money. And remember: volatile items like food, energy, and healthcare are not included in that 3%.
Retirees need to ensure that their investments grow at least enough to offset the effects of inflation. They need to keep some portion of their portfolios in growth stocks to make sure that the money they receive from their investments each month purchases the same amount of goods and services that were purchased in the past.
Examples of Inflation
Businesses around the world often struggle with the effects of inflation and what to do about rising costs. If a business experiences an increase in the prices of the goods and services that go into making a product, it can do one of two things: keep the price the same and make less money or risk loss of customers by raising the price, which might also ultimately lead to making less money.
Examples of inflation range from restaurants that pay higher prices for supplies to shoe stores that pay higher delivery costs. And when oil prices rise, everything that is made with petroleum products rises: envelope windows, soda bottles, tennis rackets, and even pantyhose.
Deflation is inflation's ugly twin. Deflation occurs when people are afraid to spend money. The government (in the form of the Federal Reserve) attempts to get people borrowing and spending by keeping interest rates low. This eventually results in very low demand for goods and services, and is followed by prices that sink lower and lower. While this is good in regard to purchasing power, it is not good if you have debt.
In a deflationary environment, retirees who have any kind of debt need to make sure they pay it off as quickly as possible. Whether it's a mortgage, credit card debt, or a car loan, debt in deflation is paid with dollars that are worth more, rather than less.
Current Risk of Inflation
In 2011, the risk of inflation is fairly high. The current economic outlook for the United States is not very good. As private sector unemployment remains high, federal, state, and local governments take in less money to provide services. Further, federal and state governments are burdened with paying unemployment insurance. As less tax revenue comes in, services are reduced. As services are reduced, public sector employees are laid off.
The biggest problem for the US right now, however, is the massive budget deficits at both the federal and state levels. The federal government has been able to continue selling bonds to other countries in order to finance ongoing operations, but the total amount of estimated outstanding US debt as of May 2011 is over $14 trillion.
Equities, Gold and Inflation
Unlike other precious metals and currencies, gold has a universally accepted store of value. In other words, it is considered to be the world's currency. An ounce of gold is worth the same amount in China as it is in the United States as it is in Europe. Regardless of what happens with each country's currency, gold has the same value.
Investors often flock to gold during times of economic or political crisis. That's because no matter where a person is in the world, he or she could conceivably pay for something with gold. While this works in theory, it doesn't really work in practice, as not many people walk around with solid gold coins or gold bullion.
The price of gold rises and falls based on supply and demand. It doesn't rise and fall with the value of a currency. All this makes gold a solid hedge against inflation, but not without risk. Gold can also become overvalued as investors and entire countries buy it up to shore up their savings during uncertain times. The problem with gold is that no one knows what it's truly worth at particular time.
While we've covered the basics of retirement planning here, there is much more to securing a great retirement. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.
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