The most important thing to know about your retirement budget

Here it is:

Every year during retirement, everything you buy will cost more than it did the year before. 

Such is the nature of inflation.  In 1990 a stamp was 25 cents.  Today it has almost doubled to 44 cents.  A gallon of gas was $1.16.  Today you can expect to pay triple that.  A new home in 1990 was $149,800.  Today it is…well, let’s just say housing has hit a bit of a soft patch.

Multiply those increases across all the goods and services you buy during retirement—dinner out, a new car, a vacation—and over a 20-year retirement, you can expect prices to more than double (assuming 4 percent annual inflation).  That means you’ll need twice as much income later in retirement to buy the same goods and services you bought at the beginning of retirement.

How can you combat this nemesis of inflation?  Most people’s retirement income comes from two different sources: Social Security and personal savings.  Let’s look at ways to overcome inflation in each.

Social Security

Social Security has a built in annual cost of living adjustment, so most people assume that it will keep pace with inflation.  Unfortunately, that may not be the case.  Social Security adjustments are based on the Consumer Price Index or CPI.  For decades, the Bureau of Labor Statistics (BLS) calculated the CPI in a fairly straightforward manner.  They looked at a basket of goods, and determined how much it would cost.  The following year they would price out that same basket of goods and the CPI would go up or down based on the new price.

In the 90s, some in government began to argue that inflation was overstated. They argued that as prices increased people would substitute less expensive alternatives, so the “basket of goods” should be adjusted each year.  If steak got too expensive, they assumed that consumers would substitute something cheaper like hamburger.  So why not remove steak from the basket, put hamburger in and voila, inflation is under control.  Rather than implementing this “variable basket”, the Clinton administration implemented a different process that essentially achieved the same results.  The BLS began to weight items in the basket differently.  Basically, items that were increasing in price were given less weight than items that were decreasing in price.

To make matters worse, the BLS went on to make another change based on what they called “hedonics.”  In short, hedonics doesn’t simply consider the price of an item, but the value that you get from that item.  So if the price of a new car increases 10 percent, but there are new features on the car like airbags or heated seats that increase the “value” to the consumer by 15 percent, then the BLS would essentially say that the price of that car had decreased by 5 percent even though you’re paying more for it.

Applying this to your Social Security check, you can see that the annual cost of living increase built into the program won’t necessarily help you to keep pace with inflation if it is based on the fuzzy math of the CPI.  A case in point: there were no cost of living adjustments in either 2010 or 2011, even though prices for things like food, fuel, and medical care undoubtedly increased over that period.

The solution: 

The best way to overcome this hurdle is to build your own inflation factor into your Social Security benefits.  How do you do that?  Rather than waiting until full retirement age or later, the average person retires at 62 and takes a roughly 20 percent permanent reduction in benefits.  Rather than following their lead, if you wait a few years you can retire on full benefits.  Even better, retire a few years “late” and you can add as much as a third to your annual benefit (8 percent per year for those born after 1943 to a maximum age of 70).  The annual cost of living adjustment will still be understated, but it will be based on a much higher benefit amount.

Personal Savings

In the same way that inflation eats away at the value of your Social Security income, the purchasing power of your savings and investments are also constantly being eroded.  Failure to keep pace will result in your money becoming worth less until it is eventually worthless.  As we saw earlier, even a modest rate of inflation of 4 percent can wipe out nearly all of the purchasing power of your nest egg during a 20-year retirement.

To overcome this problem, you need to invest in things that have the possibility of outpacing inflation.  Understandably, however, the volatility and uncertainty of the last few years has caused many to shift their investments into things like money markets, certificates of deposit (CDs) and other “safe” investments.

Unfortunately, safe can be risky.

Consider a day in the hospital.  In 1980, a day in the hospital cost $344.  Today that same day costs around $5,310 (according to statistics published by the Wall Street Journal).  For the sake of our example, let’s assume that 30 years ago you wanted to start planning ahead for your retirement.  You thought that someday you might end up in the hospital for an illness and you wanted to set aside enough money to pay for a two-week hospital stay.  You didn’t want to risk losing the money however, so you just put the cash into your safe-deposit box.

Fast forward three decades and you’re hospitalized with pneumonia for two weeks.  When the bill arrives, you remember the cash that you stashed away so many years ago.  You make a trip to the bank, open the box, and find exactly $4,816.  Looking at the bill, you realize you’re about $70,000 short.  By not outpacing inflation, your money lost almost all of its purchasing power.

Now let’s assume that instead you invested that $4,816 into the S&P 500 back in 1980.  Even with all the ups and downs, it would have grown to nearly $135,000 by 2011.  That’s enough to pay your entire hospital bill with plenty to spare.

The solution:

So what are some ways to preserve the purchasing power of your nest egg?  First, as we just saw, you should resist the temptation to be too conservative.  You aren’t doing yourself any favors by having a portfolio dominated by “safe” investments like cash, government bonds and CDs.  These investments are less likely to outpace inflation and could even lose a significant amount of their value during high inflationary periods.  Most investors should keep at least a portion of their investments in quality stocks.

Second, consider investments in real estate, commodities or precious metals.  These types of “intrinsic value” investments tend to do well during inflationary times.  As we have seen with the current downturn, however, they can also be more volatile and less liquid than stocks and bonds, so keep that in mind.

Finally, consider investing in a real return mutual fund.  These funds invest in a wide range of investments that are designed to battle inflation, such as inflation protected treasury bonds, real estate investment trusts, floating rate bonds, non-U.S. debt, natural resource stocks, high yield bonds, currencies and commodities.

Clearly, a fixed income retirement strategy in a rising cost world is a recipe for running out of money.  By investing in a well balanced portfolio that is designed to keep pace with inflation, you can help ensure that your money not only lasts for your lifetime, but also provides you with the income necessary for security and independence during retirement.

Thanks for reading.  Touch base if I can ever help.

Joe

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