Inflation is like glaucoma.
You can’t see it on a day-to-day basis, but the erosion of purchasing power is still there. Do you remember when $50,000 a year was a lot of money and $5,000 would buy a luxury car? I do (okay, I also remember double-knits).
My dad retired in 1974 and lived 32 years in retirement! Suppose he had $800,000 on the day he retired and someone had sold him a guaranteed 5% investment that would pay him $40,000 annually for the rest of his life. That would have looked pretty good to many people in 1974 – $40,000 wasn’t peanuts back then – but after 20 years of inflation, that $3,333 per month BEFORE taxes, wouldn’t have looked so good – even at only a 3% rate, the purchasing power by 1994 would have dropped to $1,845 per month – and he would STILL go on to live more than another decade! More on that later.
Consider a 54-year-old widow who puts $2,500,000 into a guaranteed fixed-income investment yielding 4%. A $100,000 a year income sounds pretty good and the money is considered safe! But, let’s examine the situation in the real world.
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The Impact of Inflation Widow, age 54, 30-year life expectancy Assumptions:
Source: Asset Allocation, Roger C. Gibson, McGraw Hill, 4th Edition. |
The chart above shows what really would have happened. As you can see, our widow’s `safe’ money was worth less and less – and the same thing happened to the purchasing power of her income from interest. At twenty years – by the way, have you noticed people are living longer? – with maybe still a decade ahead of her, her income was worth just over half what it used to purchase; and the same was true for her principal.
And, we didn’t even factor-in taxes. That would be too scary.
What if this widow experienced what my dad did: Hyper-inflation with rising interest rates, which we experienced in the late 1970s. Many may not remember when money market accounts were paying 17% in some places and inflation was running in the teens; not a good time to be stuck in a guaranteed 4%.
Back to our widow:
Was her income certain? Yes.
Was the outcome certain? Yes, that too.
Does this mean no one should buy annuities? Of course not. Annuities can and do serve a valuable function in a retirement mix; but, remember, they should serve as a component of the solution, not the answer.
How about stocks?
It also depends because it seems quite often investors seem to be their own worst enemy – hurt more by their behavior than their investments.
DALBAR, Inc., a Boston-based firm that provides research to the financial industry published an often-cited study entitled, “Quantitative Analysis of Investor Behavior”, which compared the track-record of the average investor in equity mutual funds to that of the S&P Index of U.S. large company stocks for the 20-year period between 1986 and 2005. Based on the timing of contributions to and withdrawals from equity mutual funds, the average equity mutual fund investor earned just 3.9% while the S&P Index had an average annual return for the same period of 11.9%.
That 8-point spread represents a 67.23% under-performance – they did only 1/3 as well as the index! The major reason: The study found that investors tend to chase performance, which by definition is always past – but it’s good for the tv ratings of the investment gurus. But, look on the bright side, they apparently saved a point or two by not getting help.
So, how does the average investor protect against inflation and taxes while still not exposing his/her portfolio to an unacceptable level of volatility… and still maintain the level of liquidity required to live comfortably and remain prepared for emergencies?
The easy answer doesn’t exist; but, a workable solution likely does. My recommendation: Locate and talk with a CERTIFIED FINANCIAL PLANNER® professional. If you want to work with one that’s local to you, you can find one here. You may also be interested in our report, Why Most Retirement Planning Often Fails.
Jim
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Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional. Nothing contained herein is an offer or recommendation to purchase any security or the services of any person or organization.
