Don’t ignore the threat of inflation
While you are driving toward income independence, your money is driving in reverse.
Inflation is why.
As if you don’t have enough to worry about for retirement, the buying power of your money is likely to be significantly less than it is now because of inflation. And as if this additional concern isn’t enough, inflation makes the first day of retirement very difficult, but it makes the later days of retirement beyond difficult, as inflation continues to chip away at what your money can actually buy.
Consider the buying power of $2,500 through the lens of 1991. In 1991, $2,500 would buy you $2,500 worth of stuff. Today, you’d need $4,371 — nearly 75 percent more money — to buy the exact same stuff.
Retirement, or income independence, as I prefer to call it, is challenging because you must defer your income, grow it, then distribute it back to yourself at a sustainable rate. The three processes I just mentioned are not easy, but at least you have some control over them. Deferring your income requires not only sacrifice, but discipline. The most common method of salary deferral is your employer-sponsored retirement plan, e.g. 401(k). You decide how much you’re willing to part with now, so that you can have a solvent later.
Once you’ve decided you’re willing to part with a reasonable portion of your current income on a regular basis to fund your future, you must then find an effective way to grow it. I have good news and bad news. The bad news is that growing your money to your liking, while paying homage to your risk tolerance, isn’t easy. You’re forced to play the averages and pray that financial markets don’t decide to humble you at the wrong time. Again, you are somewhat in control of this particular process.
The good news? People are able to accomplish the art/science of growing their nest eggs every day. Although I have to admit, when it comes to your money, I don’t like when hope is the good news. Hope is not a great financial technique.
The final basic element to creating income independence is the distribution of what you’ve accumulated. You’ve squirreled away nuts in the tree, now you must determine at what rate those can be consumed. The financial industry calls this withdrawal rate or distribution rate. It’s a hotly debated topic on which virtually no one agrees. The distribution rate debate is wrought with rules of thumb that become harder and harder to justify. Your financial adviser surely has an opinion about distribution rates, and I urge you to let it dominate an entire meeting with her. Ultimately, you will make a decision about your distribution rate.
Assuming you properly navigated this agility course like a border collie on his third cup of coffee, you’re in for a rude awakening. The $2,500 per month you’re trying to replace at retirement isn’t $2,500. It’s much, much more. If you’re 67 years old now and have been planning to replace the very comfortable $2,500 of discretionary income of 1991, you’re now beside yourself in frustration. To live the lifestyle you projected forward 25 years ago, you’d now need an after-tax income of $4,371 per month.
Inflation has a mind of its own. You don’t get a say.
And when you consider what you consume more of in retirement, you begin to wish you really were a border collie. Since 2000, health-care prices have increased by about 80 percent. It begins to feel like a cruel trick. It gets worse. Sorry. Energy prices also are among the categories in which inflation has the most significant impact. Retirement is a period in which some consumer spending categories decrease, but you will always have exposure to energy costs, and your consumption of health care will increase.
If you haven’t taken into account the impact of inflation on your retirement lifestyle, you have made a horrendous mistake. Inflation is a silent assassin. It’s the primary reason why cash-heavy retirees are going backward, all the while they feel like they’ve outsmarted the volatile investment markets.
Inflation has been uncharacteristically low over the past few years. Don’t find comfort in that. For long-term planning assumption, consider figuring inflation at 2.5 percent to 3 percent per year.
It’s worth noting that your consumption habits do control your exposure to inflation to some degree. For instance, clothing and apparel inflation is relatively flat and has actually dipped into deflation over the years. On the flip side, the sticker price for a college education continues to inflate at a breakneck pace. If you happen to be an aggressive consumer of energy in various forms (e.g. fuel, utilities, etc.), inflation is very much a harsh muse of your reality.
Inflation affects your everyday life now, it will make your first days of income independence difficult, and it will make your 25th year of retirement incredibly difficult. The solution to these ills isn’t easy. You must continually defer an increasingly larger amount of your current income and outpace inflation with your investments. The temptation is to ignore inflation because you can’t see it. Do not do that.
Unfortunately, inflation is often ignored because of a feeling. “$1 million feels like it will be plenty of money for retirement in 15 years,” one might assert. It’s not. Inflation is a big reason why. The buying power of $1 million 15 years from now will be significantly less than it is today.
Personally, my attention to inflation has significantly increased over the past several months. The more I study it, the more it scares me. All I can do is save more and invest more wisely. That’s all you can do, too.