THE KEYS TO BUILDING WEALTH
Mistake 2: Failing to Plan for the Devastating Effects of Inflation
asn’t inflation disappeared as a result of the Federal Reserve’s watchful eye on interest rates? Wrong! Since 1900, we have had only 15 years without inflation. Seven of those 15 years occurred in the late 1920s and early 1930s. That period in history is referred to as the Great Depression. It should have been named the Great Deflation! It was a period of high unemployment and few dollars to spend. The prices of goods and services dropped dramatically dur- ing that period. In fact, the cost of living dropped seven years in a row! That leaves 85 of the last 100 years with inflation. Historically, there is better than an 85 percent probability of inflation, and infla- tion can create havoc with your long-term financial plan.
Rule of 72
The rule of 72 is a useful financial tool that can help you approxi- mate how long it takes to double your money. Simply divide the number 72 by the rate of return your money is earning to approxi- mate how long it will take to double your money. For example, let’s assume you have three investments, the first returning 3 percent, the second returning 6 percent, and the last compounding at 12 per- cent. How long does it take for the investment compounding at 3 percent to double?
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Inflation Risk 89
24 years to double your investment (at 3%)
Here is what we find for the lump sum of money earning 6 percent.
12 years to double your investment (at 6%)
The lump sum of money compounding at 12 percent grows much faster.
6 years to double your investment (at 12%)
Let’s look at the effect of time on these three investments in Table 4.1.
How hard you work your money is one key to building capital over time.
The rule of 72 is also a useful tool in helping us understand the risk of inflation over time. For example, let’s assume inflation aver- ages 3 percent over a period of time:
3% Inflation over 24 years (the number of years for the dollar to drop 50% in purchasing power)
Think that’s not important? Let’s assume you are retiring at age 65. What is the probability that either you or your spouse will still be alive at age 95? I recently asked a leading insurance company about the life expectancies they anticipate in designing today’s life insurance policies. For a 65-year-old couple in good health and able to qualify for life insurance, there is a 47 percent probability that one of them will still be alive at age 95. Life expectancy continues to increase. We added more than three decades to the average lifespan during the twentieth century! The fastest-growing segment of the
TABLE 4.1
Years 3% Return 6% Return 12% Return
Today $1,000 $1,000 $1,000
6 years $2,000
12 years $2,000 $4,000
18 years $8,000
24 years $2,000 $4,000 $16,000
30 years $32,000
36 years $8,000 $64,000
42 years $128,000
48 years $4,000 $16,000 $256,000
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U.S. population is individuals over the age of 85! These are today’s actuarial probabilities. Should we experience any major medical breakthroughs, these life expectancy figures will spiral upward.
Should you and your spouse retire at age 65, one of you could eas- ily live to see 30 years of inflation. It’s very possible you will live to see prices triple in your retirement years. Let’s see the effect of var- ious rates of inflation over a 30-year period. Table 4.2 projects the future cost of goods that cost $1 today, based on various average rates of inflation.
Remember the years of double-digit inflation (see Table 4.3)?
Let’s assume you retired at the end of 1978 on a fixed income of
$50,000 and you needed every penny of this income to pay your bills. Let’s see the effect of inflation on this fixed income in Table 4.4.
After just three years of inflation, retirees found their bills ex- ceeded their income by 39 percent!
What if inflation averages 6 percent over your retirement? Let’s examine the effect:
12 years to double your cost of living (6% inflation) Let’s look at history in Table 4.5.
TABLE 4.2
Rate of Inflation Price in 30 Years
2% $1.80
3% 2.40
4% 3.20
5% 4.30
6% 5.70
7% 7.60
TABLE 4.3
Year Inflation
1979 11.28%
1980 13.48%
1981 10.36%
Inflation Risk 91
Inflation has averaged over 4 percent for the last 50 years. It has averaged over 5 percent in the last 30 years. Check out Figure 4.1 to get a real understanding of inflation.
In roughly 30 years, we’ve seen the cost of a pound of cheese increase 11-fold. The price of a pound of coffee has increased over fourfold. Buying a new car today easily costs over $23,000. That’s the cost for a depreciating asset! Thirty years ago, the average home cost less than a new car costs today. But the home has gone up in value.
In 2000, inflation was 3.36 percent, followed by 2.8 percent in 2001 and 2.4 percent in 2002. The Federal Reserve Board, under the direction of Alan Greenspan, has been watching inflation carefully in an effort to keep it under control. (Note: they are trying to control inflation, not eliminate it.)
Your Future Rate of Inflation
The historical inflation numbers we just mentioned are average numbers. Your personal future inflation rate could be higher (or lower) than the averages you hear about in the news. For example, you may have children nearing college and you are frantically sav- ing and investing for this near-term event. Historically, college
TABLE 4.4
Year End Bills
1978 $50,000
1979 $55,640
1980 $63,140
1981 $69,681
TABLE 4.5
Decade Inflation Rate
1950s 2.11%
1960s 2.76%
1970s 7.86%
1980s 4.75%
1990s 2.80%
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costs have increased at a pace far greater than the average inflation rate. During the last few years, inflation has averaged less than 3 percent, but college costs continue to soar. If you have more than one child headed to college in the next 10 years, base your planning on a personal inflation rate of 1 to 3 percent greater than average. In case you are wondering, a year at Harvard currently costs $35,000.
We will look at projected costs in Chapter 6.
Energy prices are also up sharply. We saw these costs increase 10.7 percent in 2002, with continuing major increases in early 2003 before the conflict in Iraq. Often, you see or hear the news media quote the rate of inflation excluding the volatile costs of energy.
This can lead you to believe that inflation is not a problem. But let me ask you: Do you not drive a car or heat your home? Look only at the total rate of inflation.
Perhaps you are in your fifties, with college costs behind you.
Your personal inflation rate may be less than average. You are spending less, which means you are less affected by inflation, and saving more as you prepare for retirement.
Perhaps you have already retired. College costs are not a problem for you, unless you are helping to fund your grandchildren’s educa- tion. But you may have other expenses that are growing at a rate
1970s
34 cents 75 cents 4 cents
$2,853
$20,100
Today
$3.78
$3.35 37 cents
$23,600
$132,900
FIGURE 4.1 Inflation erodes your purchasing power.
Inflation Risk 93
exceeding the average rate of inflation. As our population ages, there is greater demand for all health-related care, from prescription drugs to nursing homes. Currently, the cost of these goods and ser- vices is far outpacing the average rate of inflation. Remember, the fastest-growing portion of our population is age 85 and over.
Depending on your age and health, you and your spouse may need to project an inflation rate of 1 to 3 percent greater than what you hear in the news as average. Be prepared for a major shock if you are among the 14 million retirees over age 65 who depend on health benefits provided by a former employer. Many company plans already have a cost-sharing formula for prescription drugs. More than half of the companies polled by the Kaiser Family Foundation in 2002 that have a formula in place revealed they intend to increase the retiree’s cost for prescription drugs. (Some companies in the poll don’t currently have a cost-sharing formula. A third of these compa- nies plan to introduce cost-sharing formulas within the next two years.) Even without these coming changes, retirees are already pay- ing more for health benefits than working employees. Retirees are paying 26 percent of the total premium cost on average, while active employees pay only 13 percent on average at the same companies.
Earlier, we saw that inflation averaged 3.36 percent in 2002. Begin- ning in 2003, Social Security recipients saw their checks increase by only 1.4 percent.
Personal Rate of Inflation
All of us are at different stages in life, faced with different needs, goals, and challenges. It is important to predict your personal future rate of inflation and make plans to offset those anticipated future increases in expenses. But, before you make your prediction, let’s look at how prices changed on many items in 2002. (See Table 4.6.)
You can see that the prices of many items decreased in 2002, espe- cially for items manufactured overseas. These price reductions reflect deflation in costs of goods. But, at the same time, the price for many items was increasing, especially the cost of services. (See Table 4.7.)
Inflation affects all of us differently, based on how each of us spends our money in the future. Take a few minutes to project your personal rate of inflation, not just for next year, but also for the next 30 years. (See Figure 4.2.) Why 30 years? Listen to the advice of William Huff, an actuary with Safeco Insurance. If you are age 65, you need to plan for many years to come. Huff threw out the two
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extremes, the 10 percent of retirees who die too soon and the 10 per- cent who live too long. His focus was on the middle 80 percent.
According to Huff, men in this middle group need to plan for 32 years of inflation. Women need to plan for 33 years, which would be age 98.
Market Risk versus Inflation Risk
Many people consider market risk a bigger risk than inflation risk.
This major misunderstanding has created the poverty among the elderly we see in this country today. Let’s compare these two risks.
TABLE 4.6
Items that Decreased in Cost in 2002
Computers −21%
Computer software −8%
Airline fares −5%
TV sets −11%
Watches −3%
Appliances −2%
Coffee −3%
Clothing −2%
Dishes and flatware −2%
TABLE 4.7
Items that Increased in Cost in 2002
Cigarettes 10%
Hospital services 9%
College tuition and fees 7%
Educational books 6%
Prescription drugs 5%
Legal services 5%
Car insurance 9%
Child care 6%
Cable TV 6%
Home repairs 4%
Inflation Risk 95
Market risk can be controlled. Your actions have a direct bearing on controlling market risk, as we discussed in Chapter 2. Market risk reduces over time. Serious investors (as opposed to gamblers) should be investing for a minimum of five years. Few quality mutual funds with long-term track records have lost money over five-year investment periods. Look at the 10, 15, and 20-year track records of mutual funds. Time is your ally when it comes to con- trolling market risk. The longer the time period, the more likely your investment portfolio will be successful. Remember, your investment period is the rest of your life!
Inflation risk cannot be controlled. Remember, the government is not trying to eliminate inflation, but only trying to control it. You can- not control the country’s rate of inflation. You might be able to mod- ify your personal rate of inflation by carefully monitoring your spending habits. But, if you are faced with college costs or major medical costs and related health expenses, there is little you can do to control your costs. The risk of inflation increases over time, and it has hurt people much more than market risk. Since we cannot eliminate inflation, we must anticipate it will continue and plan accordingly.
Use either the rule of 72 or the inflation table per $1000 in Table 4.8 to help you determine your future income needs based on your personal rate of inflation.
Let’s assume you have $1,000 to spend today. Let’s also assume you anticipate your personal inflation rate will be 5 percent. You will need $1,629 in 10 years to have the same purchasing power that
$1,000 has today. In 30 years, you will need $4,322 to buy the same goods that cost $1,000 today.
Do you think you might want a new car in 20 years? Assuming
FIGURE 4.2 Personal inflation worksheet/projection.
Projected inflation for the next 10 years ________%
Projected inflation for years 11–20 ________%
Projected inflation for years 21–30 ________%
Total ________%
Personal inflation (total divided by 3) ________%
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5 percent inflation, a car that costs $23,600 today could cost you over
$62,000 in 20 years. Even at 3 percent inflation, the sticker price would be over $42,000. Other expenses related to your car, such as repair costs, taxes, and insurance, will also be increasing. Have you figured all of these increasing expenses into your retirement planning?
Do you think inflation might average 5 percent during 30 years of retirement? You will live to see prices increase more than fourfold during your retirement years. If inflation averages only 3 percent, you will live to see prices increase almost 21⁄2times! Do you have a plan to offset the effects of inflation?
LESSONS AND STRATEGIES 1. Remember, inflation never retires.
2. Inflation has averaged over 5 percent for the last three decades.
3. Don’t underestimate inflation’s effect on your future. Try to guesstimate your personal rate of inflation, and base your planning on this.
4. Use the rule of 72 or the inflation table to project your future needs.
5. The failure to anticipate continuing inflation has caused more financial ruin than investing in the stock and bond markets.
6. Your greatest risk is outliving your income.
7. Over the long term, the stock and bond markets are your friends, not the enemy! Investing in stocks and bonds provides the only solution to offsetting a lifetime of inflation. From 1919 through 2000, the stock market (as measured by the S&P 500) returned on average 10.82 percent.
TABLE 4.8
Inflation Rate 10 Years 20 Years 30 Years 40 Years
2% $1,219 $1,486 $1,811 $2,208
3% $1,344 $1,806 $2,427 $3,262
4% $1,480 $2,191 $3,243 $4,801
5% $1,629 $2,653 $4,322 $7,040
6% $1,791 $3,207 $5,743 $10,285
7% $1,967 $3,870 $7,612 $14,974
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