Inflation and Purchasing Power

Hundred dollar car note
Two hundred rent
I get a check on Friday
But it's already spent
--Huey Lewis & the News

While inflation carries many meanings, a popular contemporary definition is loss of monetary purchasing power. Stated differently, as inflation goes up, the value of the dollars in your wallet goes down.

The same is true with streams of dollars coming your way in the form of income. Picking up on our previous pension example, suppose that you are 65 and begin drawing a pension income of $1,000 per month (amounting to $12,000/yr). Let's also assume that inflation amounts to 2% annually. That's the Federal Reserve's current inflation 'target,' btw. (Think about that for a second. The Fed is saying that it wants to destroy your purchasing power by 2% each year.)

What happens to your fixed income pension over time in this environment? A 2% decline in purchasing power after one year may not seem like much, but the losses compound annually. After 10 years, that $12,000 in annual income spends like it was only $9,800 in today's dollars (an 18% decrease). At the ripe old age of 85, the purchasing power of your pension would have deteriorated to about $8,000--a 33% decline.

If inflation goes higher, then your pension's purchasing power declines more rapidly. A 4% annual inflation rate turns $12,000 into $5,300 after 20 yrs. At 6% inflation, your annual pension would be worth about $3,500 twenty years later--that's a 70% decrease.

Don't think higher inflation rates can happen? In the 1970's the US saw prolonged inflation rates well above 5%. Other countries (recent example Venezuela) have experienced 'hyperinflation' where inflation rates increase by over 100% annually.

This pension example may seem arcane, but lessons here readily transfer to a mainstream asset class: fixed income. Like pensions, most bonds and CDs pay a preset level of income to their owners on a routine schedule. Inflation erodes the value of these income streams just as it does to pension payouts.

The message should be clear. Inflation, even at 'low' rates, can whittle away at the purchasing power of an income stream. How can individuals protect against the wealth-destroying forces of inflation? If you're still working, you can endeavor to be more productive so that you earn more and outpace the eroding effects of inflation on your paycheck. Retirees, of course, can't employ this approach because by definition they are no longer working.

Another way to hedge against inflation is to invest in asset classes that generate returns deemed to keep up with inflation. Asset allocations that favor stocks and some alternative assets such as gold have historically been decent inflation hedges. Retirees or prospective retirees who have built sizable investment portfolios can offset risk that inflation poses to fixed income pension benefits.

A third way to manage inflation risk presented to some prospective retirees is the lump sum pension buyout. If a decent lump sum offer is made by the pension plan, then it might make sense to take the offer and then invest the proceeds in a manner that hedges against inflation.

Personally, I suspect that inflation rates are likely to increase in the years ahead--perhaps substantially. As I consider the pros and cons of accepting the lump sum buyout recently offered by my former employer's pension plan, my inflation outlook constitutes a 'pro.'

position in gold