August, 2008
by Dr. Thomas E. Bell, CMG Member, Michelson Awardee (Retired)
Tom received his Ph.D. in Management from UCLA many years ago, and was a consultant for about 25 years before he retired. He is a recipient of the A.A. Michelson award (in 1975), has served CMG as its Treasurer and its Secretary, and has repeatedly been on the CMG Board of Directors. He retired at the end of 2005.
About the Author
Dr. Thomas E. Bell
The stock market is doing its classical thing: Climb, climb, and then slip backward dramatically. History tells us that, after a year or two, it will likely climb back up again. However, another financial situation promises to get worse, and then stay there: Inflation. It's been reasonably contained for the last couple of decades, but now it has gone up pretty dramatically, and it will likely just keep at a high level. With inflation, your retirement assets will decrease in real value every month.
You have a choice. 1) You can just accept that lots of the value of your hard-earned retirement assets will disappear before you ever get to use them, or 2) you can take action to retain (and hopefully increase) their value. Alternative 1 is clearly the easier to follow because it takes so little effort, but the impact on your retirement will likely be really bad. Alternative 2 is the emphasis of this article; it discusses how inflation is measured and reported, what it will probably do, and what you need to do. These topics are financial in nature, but they're important because the numbers on your account statement don't actually tell you your account's real value; they only tell you the number of "nominal" dollars of depreciating valuei.
We've all gotten rather relaxed about inflation as a result of the generally low, stable rate that has existed since the early 1980s. In that 20+ years we've largely forgotten the terror that inflation brought us in the 1970s. The chart at the right shows the annual inflation rate since 1921, as well as a dashed line at 3%.
Note that the last of the data (for 2007) is above that 3% line. (That line is just below the average inflation rate for the period 1982 through 2007.) The rate for 2008 doesn't show much probability of going down below 3%, especially since the rate in 2007 was over 4% and it has been above 4% so far in 2008. In fact it shows every tendency of going up as a result of increasing energy and food costs this year -- and probably for years into the next decade or so.
I confess that I was lulled into ignoring the possible magnitude of the inflation effect. There's so much to consider in investing, and in just living, that I continued on with standard, 1990s financial analysis until a few months ago. Even the impending impacts of Social Security and Medicare didn't really get adequate attention in my analyses. And then inflation took off with the prices of oil and food; that got my attention.
I have no confidence in claims that prices are higher as a result of a few "greedy speculators", and that prices will swiftly decline to levels of four years ago after just a few caustic Congressional hearings. Even if they did, the effects of underfunded Social Security and Medicare will likely make inflation a very significant problem, especially to people saving for retirement - or living off their savings in retirement (like me).
Maybe you've heard that core inflation is only a bit over 2% (not above 4%), so you've concluded that this is all an irrelevant topic. However, "core inflation" excludes energy and food costs, as well as the effects of income taxes. In other words, it's a pretty poor indicator of value in retirement. Economists in the Federal Government like to use core inflation because it's more stable than other indicators; it's just not very useful for you and me. Instead, we should be more interested in the CPIii (consumer price index, sometimes called the "headline rate"), specifically the CPI-U and the CPI-W. These are the Consumer Price Index for all Urban Consumers, and the Consumer Price Index for Urban Wage Earners and Clerical Workers. In general, the CPI-W shows higher inflation than the CPI-U; the CPI-W is used for the Cost of Living Adjustment (COLA) for Social Security benefits, but the CPI-U is far more widely used for other things. Even these probably understate the rate of inflationiii.
The consumer inflation rate you frequently hear quoted is actually the percentage difference between the CPI-U index at two different times. The value of the index is currently (June, 2008) about 217, and it shows that things now cost about 2.17 times their costs during the reference period of 1982 through 1984. I suspect that nearly everyone reading this article in the retirement series can remember 1983 (the center of that period) since it was only 25 years ago. The period since then has experienced rather benign inflation (averaging just over 3% per year), but the prices of goods and services still more than doubled in price. Probably you didn't realize that the money you saved 25 years ago is now worth less than half what it was when you painfully put it away.
Another inflation indicator is the Producer Price Index, actually a series of indices. The Producer Price Index tracks a variety of different finished goods, intermediate goods, and crude goods. As pointed out by the Bureau of Labor Statistics (which produces these indices), the Producer Price Index is collected in a different way than the Consumer Price Index, and the CPI really doesn't track the Producer Price Index after a lag of a few monthsiv. However, when the Producer Price Index increase is far higher than the Consumer Price Index (as it is now), a prudent person would suspect that the CPI rate just may be destined to increase.
Inflation is often called "the silent tax". When government expenditures increase, a tax increase could be enacted to cover those expenditures. However, citizens might object to the tax increase. Instead, the government can issue more debt that, unless it is bought by foreigners, effectively increases the money supply with consequent inflation. Inflation extracts its tax without making itself apparent unless you're looking for itv. In most cases, some combination of increased explicit taxes and the silent tax will likely exist.
Of course, other sources of inflation also exist. The global supply of petroleum has generally been limited over the last few years, but the demand has continued to increase. Elementary economics tells us that this situation will lead to price increases, and rather inelastic demand will lead to significant price increases. The same situation exists for other commodities like corn. The message from economics: Expect inflation.
If you really want to retire some day, you need to be looking for it and taking actions to protect yourself. Don't let it sneak up on you; the effects may well be far greater in the future.
The low inflation rate experienced by the US over the last 2½ decades has "only" caused a decrease in value of a bit over 50%. That can change rapidly, and it shows signs of doing so. The graph to the right shows the decrease in value caused by different rates of inflation. Perhaps we'll experience inflation of 7% over the next couple of decades. (The average rate for the period 1969 through 1982 was 7.8%.) If so, only 5 years is needed to decrease value by 30%; in ten years 50% is lost.
If your retirement assets are in a mutual fund yielding 5% after management fees, and inflation is at 7%, you'll lose 2% of your real value each year. If you have some nice, secure bonds yielding 4% and have to face inflation of 7%, your real value will be decreased by 3% each year. The return after inflation is called the "real rate"; it's what you need to focus on, but many people are missing this point. Using the "nominal" rate (the one that's quoted for bonds) implicitly assumes that you'll experience zero inflation. Not likely.
Nice, high-quality bonds (generally with low interest rates) can be a problem; they pay less than a (possibly) high inflation rate. Bonds with long maturities (e.g., longer than 10 years) expose you to significant risk from declines in value due to inflationvi. After I thought about what inflation might be over the next few years, I decided to start selling my longer bonds (during the last month). I'm still in the midst of doing this. However, the costs of buying and selling bonds are significant, especially for selling them when higher inflation is our probable future. Oh well, I should have thought about inflation before I bought those bonds.
If large cash amounts (at least on a percentage basis) are a part of your retirement portfolio, you should consider investing them in assets that hold their value in the face of inflation. If you continue to hold a large amount of cash while inflation increases, your cash will just continue to be worth less and less. Some suggestions about alternative assets are given below.
Some assets are especially important to manage in the face of inflation. Fixed annuities (which probably pay off when you retire) will have far less value after several years of inflation than you'd expect. An even larger decrease in value will probably be experienced by long-term care policies if they aren't inflation adjusted because the inflation in medical costs is greater than the general inflation in consumer prices. Long bonds (maturing more than about 10 years in the future) will mature and pay with dollars of much less value than the dollars you pay to buy them today. However, this obvious problem makes their value decrease immediately after investors come to believe that inflation will occur, so it's advantageous to sell those long bonds before the bulk of investors reach that conclusion.
Long maturity CDs fall into the same class as commercial, municipal, and government bonds. So should you adopt a strategy of selling them off as quickly as possible? The answer depends on the specifics of your investments, and your expectations about explicit taxes. Specifically, CDs had very good yields recently, as did tax-exempt municipals. Either the bonds themselves, or mutual funds holding them, may be worth keeping because of the likely changes in the bond marketplace over the next few years, especially in the face of probable increased taxation. The value of fixed-income instruments is very dependent on expectations of the future, including interest rates, tax rates, and inflation ratesvii, so deciding on these investments should use the same analysis as purchasing investment assets.
At a minimum, that analysis must make some projection about the future state of inflation and tax rates.
Each person needs to make his/her individual projection about inflation and taxation in order to decide on how to invest. I don't know what inflation rates and tax rates will be, but I can suggest some driving factors that may determine the result.
Over the next two decades, the following may be important factors determining inflation and taxation (in addition to others) for you to consider:
Will all of these come to pass? I don't know, but I see no reason to doubt the nation's demographics or the lack of "prior funding" in government retirement plans. And I know you should consider the implications on your own retirement.
Instead of being really coy and refusing to give you any idea about my personal beliefs regarding inflation, I decided to provide you with three guesses that I've been using. The first is the minimum inflation rate that I can foresee over the next two decades, the second is my "moderate inflation" rates, and the third is my "rampant inflation" guess. A special word of warning is necessary here: My assessments may well be two to three years ahead of when things really happen (a common situation for me), and sometimes they are totally wrong.
Nevertheless, I'll give you my working hypothesis and you can respond by giving me yours (please). My working assumptions about levels of inflation are as follows:
The column in the above table labeled "Rampant Inflation" predicts a really grim situation, so maybe it's totally absurd. However, this graph plots these values in the same way as the actual values (before 2008) are plotted, but it shows what the situation after 2008 might be. The tan line shows Rampant Inflation, and the red line shows Moderate Inflation.
The points after 2007 don't actually look so absurd in the context of the historical data. Some people claim that foreigners will continue to buy US debt indefinitely, and that new regulatory mechanisms in the economy will preclude the difficult inflation situations that have occurred in the past. However, the economy hasn't previously had to deal with the industrialization of China, India, and major part of the Middle East. Nor has it had to deal with Baby Boomers taking Social Security and Medicare benefits.
Still other people maintain that a good, old-fashioned recession will limit inflation expectations, that we will probably have one in 2008, 2009, and/or 2010, so we can pretty much forget about inflation. And some indicatorsix show that inflation expectations may only be about 2.3% per year.
I don't know whether we'll be faced with rampant inflation or even moderate inflation, but the "Moderate Inflation" column certainly doesn't seem very large in the context of what might happen if inflation is rampant. I'm personally convinced that we'll have inflation at 3% or more (on the order of 5% to 7% over the next 20 years, and I'm betting much of my retirement money on it.
Please let me know your projections by emailing me at .
If inflation will be a major part of our economic future, putting all your retirement savings into long-duration bonds with fixed dollar payouts would not be terribly rational. Nor would buying an annuity with a fixed payment. You need some better alternatives.
At least one book is available to help you identify opportunities for investing in inflation protected alternativesx. However, you might be interested in a few obvious investments that will likely retain their value better than cash or those secure, long-term bonds.
Real Estate: Your home may well be your most valuable asset, and its real value is pretty much independent of the inflation rate. Unfortunately, a "housing bubble" has just occurred, and the value of your home may be questionablexi. You may not have a choice in whether to invest in residential real estate; you need somewhere to live. In general (over 10 years or so), real estate maintains its value in the face of inflation.
Commodities: I certainly wish I had invested in oil when I decided it would be a great investment (about 5 years ago). However, I decided that (in spite of the potential financial payoffs) I was not skilled enough to invest in oil or other commodities. I once had a client (a very skilled commodities trader) who told me that he made money by trading against people like me. I was in his office one day when he told his own mother not to invest in commodities because she just didn't know how to beat him; those guys are ruthless. Maybe you're knowledgeable enough to take the plunge; I'm not.
Stocks: Equities tend to be reasonably independent of inflation, but their inflation-adjusted return hasn't been very encouraging over the last 10 years. (A report in The Wall Street Journalxii recently showed that the real value of the indices hadn't increased over 10 years. It was rather disheartening to lots of traders. At least those traders probably didn't lose the big money that holder of long bonds likely will.) I look over more than 10 years, and I find that stocks have done reasonably well. Currently I have about 58% of our retirement assets (not including our home) invested in stocks. I generally have returns greater than the indices, so I don't plan to abandon equities.
Inflation-Linked Bonds: Treasury Inflation Protected Securities (TIPS) are bonds issued by the Federal Government that provide interest income on their principal, but they also adjust their principal to keep their real value constantxiii. I hadn't been very interested in TIPS because, I thought, their interest rates were so low. And then I realized that the real interest on normal ("nominal") bonds will probably be NEGATIVE in the future; I'm guaranteed a POSITIVE return on TIPS. (The earlier assessment was another case where Dr. Bell blew the analysis.) So I called up my broker (Joe Delano) and asked him what TIPS he might be able to suggest. He gathered information for me about both TIPS and the commercial bonds that are generally equivalent. Some commercial bonds on the "secondary market" have interest rates 150% of the inflation rate, but their principals remain in nominal dollars. I took a week to develop a spread-sheet for evaluating the alternatives, and then I invested in both Government and commercial bonds. I intend to make more investments in inflation-linked bonds to protect my retirement assets. If your broker can't help with these bonds, send Joe Delano an email.
The old technique of putting your cash under the mattress (or in a low-return fund where management fees eat up all the income) will protect you from the possibility that other kinds of investments will end up being something stupid. However, the probable rate of inflation indicates that putting it under the mattress will be at an unacceptable level of stupidity; you need to look around for investments that will protect your assets and give you (at least) some real increase in value. A future article in this retirement series will discuss asset allocation so that your risks can be controlled and you can experience an increase in REAL value.
The 1990s are gone. The easy analyses won't work in the new decade for ensuring that your retirement will be funded. If you were getting ready to retire in 1985, you were faced with a much simpler situation than today. Get over it. You have work to do!
Whether your retirement assets are in 401(k)s, pension plans, or in your own hands, make sure that they will survive dramatically increased inflation. If the current investments won't withstand inflation, find out how to move them to investments that will protect them. No one can accurately predict what inflation will be over the next 20 years, but I'm pretty certain that it won't be at, or below, 3% per year.
Many people don't appear to be sensitive to the distinct possibility of significantly increased inflation; maybe they just believe that the last 20 years have established a "new normal" where major inflation won't happen. If you choose to be in that crowd, you have all my condolences. If you're more interested in protecting your loved ones than in finding a way to avoid doing analysis and making decisions, assess your alternatives and TAKE ACTION.
If you'd like to reach Joe Delano or me, please put [CMG] at the beginning of the Subject Line in an email. Our e-mail addresses are: