Wednesday, May 29, 2019

Remember Inflation?

I've noticed lately that our country is highly polarized.

No, I'm not referring to social media or cable news. I'm thinking about the great divide between Baby Boomers and every other younger cohort on the topic of inflation risk.

Baby Boomers worry about inflation.

Many of us graduated college into the jaws of 1970s "stagflation" (a terrible-sounding word describing a stagnant economy with high inflation) and watched our grandparents' pensions, paid in nominal dollars, slowly disappear over two decades as they aged. It was common to hear them say, "We're living on a fixed income" but they were not — they were living on a disappearing income in terms of purchasing power.

Fast forward to 2019 and a GenX'er recently suggested that we "old-timers" have too much fear of the "big bad inflation wolf."

I have no idea whether inflation rates the likes of which we experienced in the 1970s and 1980s will reappear anytime soon. Long-term inflation is unpredictable. I hope the GenX'er is right but I'm not willing to bet my retirement that he is. High inflation can be catastrophic and when we plan for retirement we should take catastrophic outcomes off the table when we can.

Inflation peaked at over 13% in 1980. I had a 14% mortgage.  Inflation rates were even higher in earlier decades. But annual inflation is a snapshot. Prolonged inflation is the real monster.

I stumbled across the following chart recently at inflationdata.com[1]. It shows historical annualized inflation rates by decade. Inflation for the decades of the 1970s and 1980s averaged 7.25% and 5.8% per year, respectively. Again, much lower than the annual peak in 1980 but destructive in its persistence.


We can now update inflation from 2010-2019 to 1.78%.

Notice that periods of high inflation come and go with no regularity. Also, notice that the high inflation of the 1970s and 1980s was immediately preceded by very low inflation in the 1950s and 1960s. No one saw it coming.

We sometimes speak of high inflation rates as "tail risk" but four of the previous eleven decades experienced average annualized inflation significantly higher than the long-term average of 3%. We haven't seen high inflation since the 1980s so we're probably experiencing recency bias.

There are a number of ways a household can mitigate inflation risk. I will write about one, CPI-adjusted annuities, soon. In the meanwhile, you can read a paper that economist, Zvi Bodie and I recently co-authored on that topic[2].

Buying TIPS bonds instead of nominal bonds is a near-perfect inflation hedge that transfers inflation risk to the U.S. Treasury. Your home equity might keep up with inflation. Social Security benefits are inflation-adjusted.

Although stocks are commonly referred to as an inflation hedge, they are not truly a hedge because real equity returns are not correlated with inflation. Stocks typically perform poorly in times of high inflation. Rather than "protect" against inflation they more or less "eventually outrun it", which is fine if both you and your portfolio survive long enough.

Economist, William Sharpe was recently quoted on this great divide. "I realize that it is hard to make the point that inflation can get out of control with the generations that grew up after the early 1980s, but perhaps we can point to other countries in more recent times, then ask them whether they think we are virtually guaranteed to have low and relatively steady rates of increases in prices for the rest of their lives.”

It's a good question to ask yourself or your advisor.

Don't forget inflation.

In my next post, The Real Cost of Nominal Annuities, I'll share some thoughts on hedging inflation with CPI-adjusted annuities.


REFERENCES

[1] inflationdata.com.



[2] Hedging Inflation Risk with Real Annuities, Zvi Bodie and Dirk Cotton.




10 comments:

  1. most indexed assets, e.g. "real" annuities, tips, social security, are tied to the cpi-u. whatever one's criticisms of that index might be - chain pricing, hedonics, substitutions [e.g. chicken for steak] - it is clear that that index doesn't track the actual expenses of retirees.

    medical care, for example, is woefully underrepresented in the index, scarily inflating in cost, and a growing expense over the course of retirement. food and housing, i suppose, would be another couple of similarly distorted categories.

    i keep looking for a way to hedge the inflation in the things that i actually spend money on.

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    1. A valiant effort, Jeffry. Keep us posted. In the meanwhile, I wouldn't ignore the value of CPI-U inflation adjustments because they aren't perfect or, as they say, don't let the perfect be the enemy of the good.

      Best. . .

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  3. You dismiss the annuity comparison technique of the "additional cost" of hedging inflation with a nominal annuity. But with a typical (non-COLA) pension, this is exactly the problem faced by retirees. Given a fixed monthly (or annual) pension, how much additional savings must I have to provide adequate inflation-protection to the income stream?

    It would be nice if there was some study of this problem. Even a Bengen-style analysis (a-la the "4% rule") would be very useful.

    My own calculations say that for a $X/yr pension, and investing the savings in S&P500, a total of $20.6*X of additional savings is needed. For investing in TIPS instead, a total of $16.6*X of additional savings is needed. These are over the period 1871-2018, with the worst (of course) being retirement in late 1960's or 1970's. Note that these are not significantly different than the $25*X investment needed for a "4% rule" withdrawal plan without the pension. These are terrible, and make the pension nearly worthless for retirement planning.

    (with the TIPS investment, and covering less than 100% of potential retirement years, it is still an uncomfortably large factor---covering 80% of cases needs 11.8*X, covering 90% of cases needs 15.2*X, and covering 95% of cases needs 16.0*X. Not much better.)

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    1. Bill, as I will explain in a post next week, hedging is free.

      I think you're pointing out that most pensions aren't adjusted for inflation and asking how much income you would need to replace the loss of purchasing power from one. Inflation is unpredictable, so I don't think that is a question that can be answered. You could look at historical inflation and calculate how much you would have needed in the 1970s as possibly worst case but a "Bengen-style" analysis would only give you an average.

      I recently recommended that households with limited assets might save as much income as possible early in retirement and invest that in I-bonds to spend later.

      But you are correct. You can purchase a real annuity but most pensions are not inflation-adjusted so there is no easy answer.

      Good question. Thanks for writing.

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  4. It seems like a long time ago, and for anyone other than a Baby Boomer it may be hard to fathom, but when I bought my first house in December of 1980 the interest rate on a Mortgage Loan with Zero Points was 15.75%. I remember how excited (and relieved) I was to learn that the Seller had a Mortgage that could be "assumed" with "only" a 13.75% interest rate and no additional closing costs.

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  5. The high-inflation decades coincide with WWI, WWII, and the oil shocks of 1973 (OPEC-induced shortage) and 1979 (Iranian revolution). Domestic policies may have exacerbated some of these, but all were caused by external forces.

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    1. Yes, and all unpredictable just a few years earlier. I'm not sure what external force might have been responsible for the 1910's.

      I read a really interesting study of the 70s-80s inflation that blamed a lot of it on economists. The interesting conclusion was that, given today's Fed policies back then, we wouldn't have avoided it.

      There are many studies of that era, though, and they don't all come to the same conclusions. The only conclusion I can come to is uncertainty.

      Thanks for the comment!

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  6. Guns AND butter in the 60s yielded inflation thereafter until expectations were walked back, imho. Recall looking at a CA $180k 2 bedroom apartment in 1980 with a $100k 13.5% mortgage plus 2 balloons, $20k at 18% due in 2 months and $60k at 16% due in 6. We fled.

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