An Economic Fireball

A trip to the old fashioned Green Harbor General Store is one of my favorite summer traditions. The small town atmosphere, appetizing cooking aromas and interesting merchandise mix lulls me back to a simpler time. My niece and nephews also enjoy the atmosphere but what really gets them excited for the trip is the well-stocked penny candy section. They dart across the wooden floors, grab a red bucket, and then the tough decisions begin. Will it be 3 cow tails or 5 sleeves of smartees? I give them a budget to work with and sometimes I’ll bring a calculator as a deterrent to youthful fuzzy math. One of the kids, who will remain nameless, will try any trick to score an extra banana split or squirrel nut. I’m on to him.

After the candy is selected and the tab is paid we’ll pose for a picture among the candy jars. I figure the kids will cherish this photo later in life. Once I post this picture on Facebook I get the usual responses. My friends tell me I’m a good uncle and I appreciate the compliment. But I also know my intentions aren’t completely altruistic. This trip provides a brief return to my childhood and the many visits to Smiley’s Pharmacy in Braintree Square. The other typical comment is a lot more sobering to me as a financial planner. Friends will ask “Is there such a thing as penny candy anymore?”. The answer is no. This is one of the few occasions I can get people to talk about a major economic evil, inflation.

That word sounds almost as ugly to me at its antonym, deflation, sounds to any Patriots fan. It makes many cringe. Inflation is the financial fireball that sent our mothers back to the workforce in droves in the early 1980’s. The Arab Oil Shock of 1973 marks the start of real wages (that is wages adjusted for inflation) decreasing in the United States. Family budgets were already under immense pressure by 1980 when the annual inflation rate was 13.58%. Even a 10% raise that year left you behind the 8 ball. A lot of families simply had no choice. Mom had to supply a second income and go back to work. Then, everyone became so damn busy. I can understand why few of my peers want to talk about inflation. It’s an unpleasant topic. Besides, 70’s kids are still working and earning wages paid in current dollars. Inflation is easy to forget.

Plenty of older retirees only wish they could forget inflation. Their standard of living has declined because they failed to adequately plan for the effects of inflation over a long period of time. Workers nearing retirement and recent retirees should understand they no longer have the luxury of sweeping financial decisions under the carpet. At age 65, the life expectancy of a man is 19.3 years and the average woman could live another 21.6 years. These are merely averages. One quarter of today’s 65 year olds will live past 90 and one out of 10 will live past age 95. You must plan for inflation early in your retirement, because by the time you start feeling its effects it could be too late to do anything.

Let’s consider this example. Jane Smith retired at age 65 in 2006. She’s one of the lucky ones, as she has a company pension of $4,000 a month. When she combines this with her social security benefits, Jane can live quite comfortably. But as her pension is not adjusted for inflation. Every day, week, month and year inflation is quietly creeping up on her. The package of coffee shrinks but the cost remains the same; her Medicare supplement plan increases its premium every year; the durability of the clothes she buys declines and the price goes up. As the average annual inflation since 1913 is 3.22%, Jane will certainly notice the budget squeeze 10 years into retirement. Her 4,000 monthly benefit in 2006 dollars will have the purchasing power of $2,880 in 2016 dollars. In other words inflation has handed Jane a 28% benefit cut in 10 years. Her financial situation will only get progressively worse. At a 3.22% annual inflation rate, prices double every 20 years.

As I’ve said, Jane is one of the lucky ones. She has a company pension and will receive a check every month no matter how much inflation eats away at it. For retirees with 401k’s or IRA’s invested too conservatively the math is much more ominous. They will have to withdraw an increasing amount of money each month to maintain their standard of living. It is a frequent financial planning mistake to retire at 65 and place your savings in bank CD’s. Many people consider this a “safe” investment, but I beg to differ. Investors in CD are virtually guaranteed to lose money in real terms. You can outplace inflation by allocating a portion of your retirement income to stock and bonds.

Such investments may sound scary to some people, as many of us are not comfortable stock market risk. I can’t blame anyone. After working all those years, no one wants to lose their hard earned savings. But while it can be quite volatile, over time the stock market goes up more than it goes down. While its growth is never a straight line up, you have an excellent chance of winning over the long term if you are invested properly. So retirees are confronted with a choice: slowly but surely succumb to inflation and suffer a reduced standard of living. Or, tolerate stock market volatility and probably maintain, or improve, your lifestyle.

You will need to discuss that choice with your advisor. But understand a key difference between stock market volatility and inflation. Every business day the evening news reports on stock market performance. If there is a sizeable decline in the market, there is extended sensationalized coverage. The “Money Honey” gets on the tube and comments on the decline with exasperated tones. The headlines like “Carnage on Wall Street” scream bloody murder. Everyone looks for some explanation for the reasons, but experienced investors have come to expect short term stock market declines and it doesn’t keep them up at night. In fact, a lot of rich people just yawn at the news and change the channel.

News on inflation usually never comes with such melodrama because it’s gradual and boring. It’s also not any surprise. Only eggheads and number nerds like me want to hear monthly inflation figures. Imagine this scenario, January 1st you place $100,000 in a home safe. Since it is not invested at all, you’re losing $3,220 per year or $8.22 per day in real terms. What if I rang your doorbell every evening and told you “your money is now worth” in successively declining amounts. Disregard for a moment that I’m a big annoying oaf. How long would you let this continue? At the end of the year you will have $96,780. Would this make you uncomfortable and prompt to reconsider your financial strategy? At the end of 10 years you’ll have $72,839, but I’m sure you would have somehow put a stop to my visits years prior to that. Maybe even using a pitchfork?

Having a plan that includes inflation beating investments may make you more comfortable with your finances. Talk to your advisor about your asset allocation. I am not recommending that anyone take more risks than they can handle. I also firmly recommend that any money you need over the next 5 years be in cash; money to be spent now or soon should never be at risk in the market. Recognize that you must be proactive about the dangers or inflation. If you only appreciate the peril in your twilight years, it’s too late to take action.