Effect of Inflation on a Dollar – Why You Need to Factor Inflation into Your Retirement Plans

Doug Nordman March 2, 2011 0

It’s hard to appreciate inflation‘s corrosive effect on a retirement portfolio. From one year to the next it’s so tiny that it’s barely perceptible, and everyone has a different set of personal expenses that are affected by inflation at different rates.

The following graph shows the corrosive effects of inflation over four decades. (If the image isn’t displaying for you then a PDF link is at the bottom of this post.) The lowest rate, 3%, is approximately the average rate of inflation over the 20^th century.

The Impact of High Inflation Rates on Spending Power

The highest rate on this chart, 5%, is the approximate average inflation rate over 1970-2000. These years are notable for the 1970s oil embargo and the 1973-4 stock market crash, the October 1987 stock market’s one-day drop of 25%, and the 1990s run-up of technology stocks.

Annual inflation rates reached double digits in the 1970s-80s and required extraordinarily aggressive intervention by the Federal Reserve to return inflation to “historic” levels. During one year of this time, military pensions even received two cost-of-living-adjustment raises in the same year!

Why Early Retirees Need to Consider Inflation

Early Retirees (ERs) have to consider the effect of inflation for two reasons.

First, ERs will spend a much longer time in retirement (perhaps more than 40 years) and during that time will see inflation erode their original ER dollars to as little as 13-30 cents. The COLA in a military pension goes a long way toward neutralizing inflation. The same goes for any inflation indexed pension or annuity, including Social Security Benefits, which are indexed to inflation. Learn more about the Consumer Price Index.

The second important point about inflation is its effect on an investment portfolio’s asset allocation. Only one asset class has historically beaten inflation over the long run of 20-40 years of retirement: stocks. An early retirement depends on multiple streams of income from pensions, Social Security retirement benefits, and investments.

Most ER survival projections expect to consume at least a portion of the ER investment portfolio’s principal and not to just live off dividends. ERs cannot hope to survive by investing their portfolio in TIPS or I bonds and expecting to “win” by keeping up with inflation.

They’ll need to cut their lifestyle to stay within the income of their pension/Social Security or to assume greater market risk (volatility and loss) by investing in stocks. Or they’ll have to stay in the workforce for a much longer time.

How Inflation Impacts Military Retirement Pay

There’s one other aspect of inflation to consider for service members tempted by the REDUX retirement system. One “feature” of a REDUX retirement is that COLA increases are one percent less than the CPI. That doesn’t sound like much of a loss next to the prospect of receiving $30,000 five years before retiring, but the reality is that it equates to 1% higher inflation for at least 20 years of retirement.

The difference between 3% inflation and 4% inflation for 20 years amounts to 10 cents out of every ER dollar. After the first 20 years of ER, a $20,000/year REDUX pension loses over $2000/year every year over a High-Three pension and, over an ER’s lifetime, will add up to far greater losses than the prospective gains of the $30,000 REDUX bonus. We’ll re-visit this REDUX COLA effect in a later post.

In short, REDUX is a terrible deal for retirees.

Average inflation rates and historic stock returns are from Dimson & Marsh’s “Triumph of the Optimists”. If you want to have a little fun with historical inflation rates then try the “What’s a Dollar Worth?” calculator.

For those of you readers who have done a bit more research on inflation, the next post will talk about some of the popular controversies: the COLA watch, whether or not the CPI is manipulated by a global conspiracy, the challenges of a portfolio of only TIPS and I bonds, why state quarters are a bad investment, and how Groucho Marx handled inflation in his day.

The graph of inflation effects was challenging to post because WordPress has a few kinks in its display features. If the Scribd image isn’t displaying properly, here’s another link to the inflation graph.

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