Inflation - The Devil You Don't Know

Feb 11, 2007

This week I pen this column as a continuation of my last column "Living Longer is a Risk?", to study what I consider to be one of the most significant risks boomer retirees face....Inflation. Better the Devil you know than the Devil you don't is an old proverb that we will put to new use today as we study and compare the devil we know - today's low interest rates, to the devil we don't know - inflation.

Inflation is measured most commonly by our government as the Consumer Price Index. The Consumer Price Index (CPI) is a measure of the average change in prices over time in a market basket of goods and services. The Bureau of Labor Statistics releases CPI data monthly. The recent trend of inflation has been higher, albeit well contained in the Ben Bernanke range of comfort. The effects of inflation can be stated in terms of statistics, but probably the best illustration is in a real life example. Think of the first home you and your family bought...maybe some 30 or more years ago. Think of the price you paid (maybe this was all of the money you had in the world). Now, think of the price you paid for your most recent new car.....was it $22,000, $30,000, or even $42,000 for a new Suburban. This is a great real life example of the effects of inflation on the average consumer. Now imagine what could happen to your retirement nest egg if not properly invested to keep up with inflation, or worse yet, if your nest egg is emptied by some unforseen health issue.

Now let's dig further into the CPI statistics to see why your real life experiences with inflation recently do not match what the federal government says is a low and well contained problem. While several factors can result in the national CPI being different from your experience, one major factor is how you actually spend your money. Estimates of expenditures reported in the Consumer Expenditure Survey for each consumer good or service are used to produce "expenditure weights" for the CPI. These weights give each good or service in the CPI an importance relative to all the other goods and services in the market basket. For example, an increase of 5 percent in housing costs is more important than the same increase for telephone charges, because most consumers spend more for housing than for telephone service. Similarly, like most retirees, if you spend more on medical care and recreation, and prices rise sharply for these goods and services, the increase in your personal expenditures and personal price index would be larger than the increase for the average consumer. The CPI represents all goods and services purchased for consumption by a reference population BLS has classified into more than 200 categories, arranged into eight major groups. Major groups and examples of categories in each are as follows:

FOOD AND BEVERAGES
HOUSING
APPAREL
TRANSPORTATION
MEDICAL CARE
RECREATION
EDUCATION AND COMMUNICATION
OTHER GOODS AND SERVICES

As you can imagine, the costs of medical care are significantly different for a group of thirty somethings than they are for a group of sixty or seventy somethings. This leads to a very different index of inflation with some startling numbers called the CPI-E. The Bureau of Labor Statistics has collected data from 1983 to the present on the basis of an experimental index (CPI-E) for Americans 62 and older. The index uses a "basket" of goods and services more relevant to this group, which spends more of its money on items—such as medical care— whose costs have grown more rapidly than other expenditure items.While the commonly quoted CPI is figured at 3% annual inflation (the increase for 2007 will be 3.3%), the CPI-E is slightly elevated at 3.38%. Specific expense categories such as food, apparel, transportation, recreation and education, all drop when moving between the and the CPI-E. There is an average 24% decrease in the amount of money spent in those categories after retirement. In the categories of housing and medical care, however, the CPI-E shows increases of 22% and 102%, respectively.

How should retirees estimate their retirement living expenses? The answer is carefully and thoughtfully, especially when taking into consideration the likely changes in spending habits that will occur as they age. Today's low interest investing environment makes the challenge even more difficult, as the natural reaction is to put your investments into "safe" low yielding money markets and CD's that barely outpace and in some cases don't even keep up with inflation. While there is no easy answer, the best advice is to seek a professional planner for a retirement plan that can outpace inflation and protect your assets.

The Retirement Guy