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

Living Longer is a Risk?

February 1, 2007

I begin writing this entry tonight with an admission that it is hardly a subject that we can cover completely, much less solve, in a few paragraphs. The importance of addressing the fact that you may outlive your assets is neither pleasant, nor is it something we want to admit, but we must focus on planning and managing our retirement resources in a manner that they do not expire before we expire. Boomer retirees have prepared themselves for a retirement similar to that of their parents and older relatives. They do, however, tend to underestimate the gains in life expectancy that have happened during their lifetimes. As a result, many boomers are now in danger of outliving their assets.

I recently read a paper put out by the AARP that covered the four pillars of retirement.
1. Social Security
2. Pensions and Savings
3. Post Retirement Earnings (think Wal-Mart greeter)
4. Health Insurance (both adequate and affordable)

Sadly, for the majority of retirees, Social Security is the foundation of their retirement, representing the only guaranteed income that most will have. According to the SSA, nearly 2/3 of beneficiaries get more than half of their income from Social Security. With this years COLA adjustment, the average benefit will now be $1044. Less than half of working Americans today have a pension plan, and less than half have no regular payroll deduction savings as well. I just heard on NPR's marketplace, that today consumer savings reached their lowest level (-1% if you can imagine) since the great depression of the 1930's, and many have retirement savings far less that sufficient to live in retirement three decades or more. The baby boomer set also carries the burden of having the most debt in addition to their lack of retirement resources. Many boomers will be blindsided, not knowing until it is too late that they have not saved enough to live a comfortable retirement.

Perhaps the largest concern for newer retirees, and an increasingly alarming statistic, is the declining number of employers offering health benefits. This is probably the most overlooked area of retirement planning, and one that could add anywhere from $400-$750 per month to adequately insure. Not mentioned in this pillar is long term care costs which many mistakenly believe are covered in their medicare.

Finally I will focus on the effects of inflation, which most only consider in passing as a line on the retirement calculators that we sometimes like to use. Most , savings, and other guaranteed sources of income (annuities e.g.) do not have COLA adjustments. Inflation that has been running at the average 3% rate we've seen in the last year will cut purchasing power in half over the course of a 15 year retirement. The danger, especially for those who depend solely on Social Security for their income is obvious.

Feel free to add your comments, or corrections where I am wrong. I will discuss in more detail the problems facing the boomer set regarding inflation in future posts. We are all going to retire at some point in our lives whether we choose to or not. Simple changes made early enough can have a profound impact on the happiness you will feel later in life. Simply put, save as much as you can, work a few years longer than you thought you would, and for God's sake pay off those credit cards! Links to Dave Ramsey are on the right. I highly recommend you visit his site.

Until Tomorrow