Wednesday, May 28, 2014

Is Inflation Tame?

I suppose the answer to that question is relative. I bought a house in 1980 with a mortgage rate of 13.875%. That priced in a lot of expected future inflation.

About that same time, I bought a 5-year CD from a bank in Rockville, MD that yielded 14%. That's right, a 5-year bank certificate of deposit paying 14%. Today's CD rates probably make you wonder if I got the decimal point in the right place.

Inflation expectations declined rapidly during that five years and when I went back to the bank on Rockville Pike to cash it in, the banker took one look and shook his head.

"Is something wrong?" I asked.

"No," he replied. "I just can't imagine that we were ever willing to do this."

Those of us who lived through 70's and 80's inflation know how it can wreck your finances. Some of us learned to deal with it and even to profit from dis-inflation. I bought that house cheap because not many buyers were willing to take out a mortgage then and I refinanced several times over the next twelve years as mortgage rates declined precipitously. The price of that house more than doubled and my mortgage payment just kept getting smaller. It worked out nicely.

Compared to those decades, inflation since 2000 has been a relatively tame 2.73% a year. The long-term average since 1913 has been 3.22% a year. So, for those who retired around 2000, inflation hasn't been much of a problem, right?

Actually, it has.

Robert Powell's Retirement Weekly newsletter this week pointed out the results of an analysis entitled Annual Survey of Senior Costs released by The Senior Citizens League (TSCL) that shows inflation has reduced the buying power of retirees by nearly a third since 2000.

How is that possible if the Consumer Price Index (CPI) has increased only 2.3% a year in that time according to the Bureau of Labor Statistics? There are two reasons.

First, Nixon-Carter era inflation ran from 8% to over 10% and hit our buying power in Katrina-like fashion. Inflation over the last 14 years, however, ate into our wealth more gently but more persistently, sort of like the Colorado River eating into the Colorada Plateau. Give rivers or moderate inflation enough time and you will end up with a really big hole like the Grand Canyon somewhere.

Second, the TSCL study calculates inflation in a way that is more representative of the spending of retirees, weighing medical and other expenses more heavily than does the CPI. This "retiree's inflation" averaged 2.6% a year from 2000-2014 while the widely-use CPI averaged a smaller 2.3% a year increase.

How can a retiree hedge against "retiree inflation"?

It isn't easy. TIPs bonds and inflation-protected fixed annuities are based on the CPI. They won't hedge for price inflation of products and services more heavily purchased by retirees.

Social Security benefits are adjusted for inflation under present law. Since 2000, the Social Security Cost of Living Adjustment (COLA) has increased benefits just 41 percent while typical senior expenses have jumped 84 percent, more than twice as fast, according to The Senior Citizens League. It's those faster growing "senior expenses" that increased inflation from 2.3% to 2.6% for retirees.

Investing more in stocks is probably the only way to outpace retiree inflation and stocks do so only indirectly. Over time, stocks do tend to earn more than the rate of inflation, but they don't typically do so when the inflation occurs. Stocks don't do well when inflation is high, but their subsequent returns might help you catch up later if you have time to wait.

On the positive side, the typical spending of retirees tends to decline about 3% a year over the long run, which is conveniently near the long-term rate of inflation in the U.S.

My recommendation to retirees would be that they not just worry about 80's-style hyperinflation. Be aware that even a little inflation will eventually cause a big problem.

Because you can't completely hedge against inflation doesn't mean that you can't plan for it. Plan for less spending power as you age. Adjust your spending to reflect your inflation expectations and the natural tendency for spending to decline as you age, anyway. E$Planner is a good tool for this.

Make sure that inflation, tame or not, is a risk that your retirement plan addresses.

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