An oft-repeated anecdote by members of our older generations is how much it used to cost to go to the movie theater. The ticket was a dollar, popcorn was 20 cents, a hotdog 50 cents, and the whole evening out set them back just a few dollars.
This phenomenon, of course, refers to inflation, and it didn’t affect retirees for a long time because people, unfortunately, often didn’t live long enough for inflation to rear its ugly head and wreak havoc on portfolios.
Inflation is an increase in the cost of goods and services corresponding with a decreasing value of the underlying currency, whether it be the dollar, euro, yuan, or ruble. 2022 has seen drastic rises in inflation levels worldwide, with Venezuela taking the crown with an inflation rate of 155%, according to tradingeconomics.com. Closer to home, Canada has seen a 6.9% rate as of November, nearly keeping pace with our own 7.1% inflation here in the good ‘ole USA.
Now, I won’t go into the philosophical arguments of whether inflation is good or bad or whether our current monetary policy is to blame for our current high inflation rates, as I am neither an economist nor a philosopher. But I do want to go over some fundamental theories, so you better understand why inflation occurs. Armed with that knowledge, we can realize how inflation affects retirement plans and take action now instead of reacting later when it may already be too late.
Why is there inflation?
We can compare inflation to a delicate balancing act between money supply, scarcity of resources, and consumer demand. If all things are equal, there is 0% inflation. An unweighted balance will lead to either inflation or deflation. Deflation occurs when the currency increases in value and goods and services become cheaper. That may seem an improvement, but economists often see deflation as an indicator of a worsening economic environment and a possible recession.
How does inflation happen?
We’ve written below a few key reasons, though the topic is complex, and economists have written many volumes that attempt to explain all the possible causes. The following reasons should suffice for simplicity’s sake and our more specific purposes.
When the cost of producing something goes up, producers and manufacturers push those costs onto the consumer. For example, when the price of raw materials goes up, goods become more expensive to produce. Let’s imagine a scenario in which a copper mine gets shut down for safety reasons. Copper is suddenly more scarce, leading to higher copper prices. Manufacturers of goods that require copper to produce pass on these greater expenses to the end-user, leading to higher prices without a corresponding increase in consumer demand.
Other factors that also influence the cost of production include wage increases, natural disasters, and geopolitical tensions.
Demand-pull Inflation (Greater Demand)
Demand-pull inflation occurs when consumers suddenly have a high demand for a good, and the production of said good can’t keep pace, leading to higher prices. Of course, if your favorite brand of peanut butter realizes a sudden surge in popularity, it’s doubtful the sensation won’t create inflation. But, if a wide range of goods suddenly become in demand, for example, through nationwide budget surpluses, demand-pull inflation may occur.
We’ve all heard of the runaway hyperinflation in Germany after WW2 that saw unlucky citizens walking through the streets with bags full of nearly worthless German Marks. Most governments have learned the lesson of printing massive amounts of more money, but, generally speaking, an increase in the pool of money available leads to more lavish spending, thus more demand, and therefore inflation.
Expansionary Fiscal Policy
A government may attempt to spur economic growth by increasing its budget. With the extra funds, it expends more on public works and employs more workers, giving more individuals more capital to thus by more goods and services. Alternatively, it can lower taxes, also giving consumers more disposable income that they will then spend on more goods and services. In both cases, a side effect of increased demand leads to inflation, which paradoxically offsets any gains made by the economic growth caused by fiscal policy.
How will inflation affect my retirement?
Finally, we get to the (not-so) good stuff. In pre-retirement, if you had a 7% Rate of Return (RoR) in one year, but inflation was 3%, then your real Rate of Return was only 4%. If inflation was higher than your RoR, you lost money. If your RoR was negative, plus there was high inflation, that is a double whammy on your retirement portfolio. Returns like that within a few years before or after retirement could spell disaster for your savings!
Read this article here —> Sequence of Returns Risk
Besides getting comfortable returns that outpace inflation year after year, you must protect your savings once you begin withdrawing from them in retirement. As the value of your dollar falls, you will be able to buy less and less than you used to. For example, an item that cost a dollar in 1997 would cost $1.85. Things cost almost twice as much as they did just 25 years ago! If you retire at 62, how will you live off of savings that have dwindled over the years that have half the value they did at your retirement?
If you had $3,000,000 at 62 years of age upon retirement and utilized the 4% rule, you would be taking out $120,000 yearly. After 15 years, you would only have $1,200,000. Using inflation rates from 2007 to 2022, that $1,200,000 would be worth 30% less than it had been in 2007.
How much do you feel you’ll need in retirement? Click here! –> Americans aren’t saving enough!
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