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Editor’s Note: Lew Mandell is at it again. The author of “What To Do When I Get Stupid,” Mandell is committed to helping his fellow boomers plan for a financially secure retirement. He’s argued for an age-in-place home and certain forms of annuities to help close the retirement income gap.
With the beginning of the Fed’s “great unwind” of quantitative easing comes the potential threat of rising inflation. Lew now explains how that threat could hurt retired folks living on a fixed income and how they can protect themselves against it.
—Simone Pathe, Making Sense Editor
In her Semi-annual Monetary Policy Report to Congress on Feb. 11, Fed Chair Janet Yellen projected that inflation would not exceed the Fed’s 2 percent target by more than a half percent. While a 2.5 percent rate of inflation would not appear to be high, think of it this way — it would double the cost of consumer goods in about 28 years. This could cause some difficulty for retired persons living on a fixed income.
Of greater consequence would be the Fed’s inability to unwind its policy of quantitative easing without allowing even higher rates of inflation. The most liquid definition of the U. S. money supply, M1, which consists of checking account deposits and currency, has increased from 10 to 16 times Gross Domestic Product in the past six years. And in the same time frame, the Fed has famously tripled the amount of Federal reserves — the money it creates “out of thin air,” as critics often put it.
Those who find themselves holding more low or non-earning “cash” balances than they really want, as the result of massive Federal Reserve bond-buying and thus lowering interest rates, face a stock market that many consider no bargain, an unappealing bond market (because if interest rates go up, current lower-interest bonds will be worth less), and a housing market in which they were recently burned. This could actually put further upward pressure on prices as consumers pour their excess money not into investments but instead into goods and services, arguably the only appealing category left. If this is accompanied by even moderate economic growth and a continued fall in unemployment, price pressure may further intensify as consumers catch up on expenditures they deferred since the downturn in 2008 and employers have to offer higher wages to attract employees.
And if the recent movement to greatly increase the minimum wage (to $15 in my area — Seattle) succeeds, wage/price inflation may be especially difficult to contain as higher wages lead to higher prices, which then necessitate even higher wages to keep up.
This should scare the hell out of those of us who are retired and living on (at least partly) fixed incomes. While we hope that Yellen and her colleagues at the Fed are able to keep inflation low, we must be concerned about what could happen to us if inflation exceeds the target by even a few percentage points. With a 6 percent rate of inflation, prices would double in about 12 years. With an 8 percent rate, they’d double in just nine years. And such numbers aren’t ridiculous; most of us baby-boomers are old enough to remember double-digit inflation in the late ’70s (to the extent we remember anything at all).
Some retirees are fortunate to have sufficient regular income to meet their retirement needs. However, for most of us, only part of our needed income, most commonly Social Security, is protected against inflation. This will be the case if we have a defined benefit pension without a cost-of-living adjustment or if we are dependent on interest from bonds or other types of regular fixed-income investments.
Many of us receive part of our retirement income from dividends on the stocks that we own. Clearly this income is not as safe from default or inflation as our Social Security retirement payments. Stock prices and dividends, in general, tend to adjust to stable rates of inflation over time, but they often do poorly when inflation is sudden or unanticipated.
So, if we can’t trust the stock market to give us reliable, inflation-protected retirement income for life, perhaps the simplest way to lock in such income is to buy an immediate annuity that adjusts its fixed, guaranteed payments to a rate of inflation up to four percent. (Check out my answers to your annuities questions).
I have calculated that adding this inflation adjustment to an annuity will cost me (a 70-year-old male) more than a third of the money that I would receive from an immediate fixed annuity without inflation protection, although if inflation averages more than 4 percent a year for the rest of my life, I would be better off buying a fully inflation-protected annuity, which would cost me a third of the benefit I would receive from a regular, non-inflation-adjusted annuity.
My decision as to which annuity to buy must be based on the overall exposure that I have to inflation and the degree to which my financial situation can adjust to inflation, should it rear its ugly head. Say I believe the doomsayers who insist that inflation will rage over the next 30 years and that I expect to live that long, mainly on a pension that doesn’t rise with cost of living. Out of fear — or simple prudence — I might want to buy inflation protection. In that case, an inflation-adjusted immediate annuity may be worth the money I give up in benefits by purchasing one.
Another way to protect the purchasing power of fixed income against inflation is by purchasing Treasury Inflation Protected Securities (“TIPS”), which the eminent financial economist Zvi Bodie (and, influenced by Zvi, Paul Solman) explained and endorsed years ago on these pages.
So-called “TIPS” work like other Treasury bonds in that they pay a stated rate of interest on the amount that you have invested. If you buy a regular Treasury bond that has a yield of 2 percent and a face value of $1,000, that bond will pay you 2 percent of the face value ($20) per year until it matures, at which time it will repay the face value ($1,000) to you. The only difference with TIPS is that the face value of the bond increases with the rate of inflation.
If you invest $1,000 in a 30-year TIPS bond with a rate of return of 2 percent of the face value, the face value will increase with inflation, which means that the value of the 2 percent interest will also increase with inflation. If inflation the first year is 5 percent, the face value of the bond will increase by 5 percent to $1,050 at the end of the year. In the second year, you will be paid 2 percent of this increased amount or $21 in interest.
(A technical note: Interest on TIPS is actually paid twice a year and each interest payment is based on the consumer price index. Therefore, the actual interest earned depends on how much of the increase in the consumer price index has occurred in each six-month period. The examples given here have been simplified to aid in understanding.)
Your total return for the first year thus includes the $50 increase in the face value of your bond and the $20 in interest for a total of $70 or 7 percent of your initial investment of $1,000. You don’t actually receive the inflation increase from the government until the bond matures, but what I am describing here assumes that you will indeed hold the bond until maturity.
The amount of TIPS that you need to cover your loss in purchasing power from fixed interest income due to inflation varies with the average rate of inflation you expect over the next 30 years, as well as with the real rate of return paid on the TIPS when you buy them.
If expected average inflation rates (over the next 30 years) were 2 percent, you would need to buy $52,257 in TIPS to cover the anticipated loss in purchasing power of a $10,000 fixed pension over 30 years. (Based on using up the entire TIPS investment in 30 years. This assumes that TIPS will continue to pay an inflation-adjusted, “real” rate of return of about 2 percent.)
At a 4 percent expected rate of inflation, you would need to purchase $88,703 in TIPS. The table below estimates the amount of 30-year TIPS you must hold to offset purchasing power loss of $10,000 per year for 30 years.
This table provides the author’s estimate of the investment in 30 year TIPS with a yield of 2 percent needed to offset average rates of inflation over that time on an annual payment of $10,000. Calculations underlying this table are complex and assume that the entire investment in TIPS will be used up (sold or matured) in 30 years.
For a little perspective, inflation in the U.S. over the past century (since 1913) has averaged 3.43 percent, although the highest 30-year rate of inflation since World War II was 5.44 percent from 1966-1995. Right now, inflation is extremely low by historical standards — around 1.5 percent.
Inflation is not politically popular, and the Federal Reserve is specifically charged with keeping it low. Therefore, high rates are not very likely over 30 years, although they did go into double digits for a few years in the early 1980s before dropping sharply once Paul Volcker’s Fed took action.
If, for example, you want to buy inflation protection on $10,000 in income and you feel that it is unlikely that inflation will average more than 2 percent over the next 30 years (although it could be higher for some of those years), you would only have to buy $52,257 in 30 year TIPS. In other words, $52,257 in TIPS would provide enough of an inflation-adjusted return to make up for the loss in the purchasing power of your fixed pension.
However, if you wanted to insure your purchasing power to the average inflation of 3.43 percent per year over the past century, you would need to invest $79,553 in TIPS because your fixed pension would lose much more purchasing power.
The large investment needed to insure a $10,000 annual payment against the ravages of inflation helps us understand several valuable points. First, we should thank our lucky stars every day for the inflation protection provided by Social Security. If we have a life expectancy of 13 years and get Social Security retirement benefits of $30,000 per year, the value of the cost-of-living adjustment alone is worth about $153,000 in today’s dollars. Medicare is also protected against medical inflation.
Second, if we are not yet retired, the 8 percent addition to our Social Security retirement benefits for each year we wait to accept payments after reaching full retirement age (currently 66) and until age 70, is fully protected against inflation, making it that much more valuable. That’s why Larry Kotlikoff constantly urges waiting until 70 to collect your full retirement benefit in his Monday “Ask Larry” columns.
There are two problems connected with using TIPS to inflation-protect lifetime income, however. First, you are protected only against average rates of inflation that resemble those of the past and not against sustained, high rates of inflation approaching 10 percent or more.
Second, 30-year TIPS (the longest maturity TIPS available) protect your income for only 30 years. If a 70-year-old lives to be older than 100 (or a 60-year-old lives longer than 90, which is a real possibility), the inflation protection will cease since the TIPS will have been used up. If that is a real concern, an additional deferred annuity that begins at age 90 or 100 could be purchased for a relatively small amount of money. Or you could buy TIPS every year for awhile to create what’s called a “ladder,” so that they will mature 30 years from now, 31 years from now (the TIPS you buy next year) and so on. That way, you never get caught short.
The takeaway is that it is cumbersome, expensive and imprecise to inflation-proof your nominal retirement income. If some of your retirement expenses subject to inflation are covered by non-inflation-adjusted sources of income, it may be worthwhile to consider buying some TIPS if you have the financial resources to do so. And while dividends on stocks will often adjust to gradual increases in inflation, high rates of inflation often cause stock values to decrease in fear of an unstable economy.
This is the reason why I include TIPS in my investment portfolio. It gives me a reasonable return on a very safe investment and it provides me with insurance in case inflation flares up again.
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