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[OPERATIONS]
Down the Road
Smart retirement planning accounts for inflation
By Bill Lynott
 Building your tobacco shop’s revenue to the point where it generates a healthy bottom line is just the first step on your journey to financial security. How you manage your money after you earn it is even more essential to your financial future.
Going up, up, up
If you’ve been around long enough, you remember McDonald’s 15-cent hamburger and may feel nostalgic when you shell out 85 cents for it today. Surprise! That same hamburger would sell today for about $1.03 if it kept pace with inflation. That popular product is cheaper today than it was 50 years ago.
Unfortunately, the bargain-price aberration in such products as McDonald’s hamburgers doesn’t extend itself throughout your personal universe of products and services. During the Great Depression, a first-run movie ticket sold for 15 cents. Adjusted for inflation, a movie ticket should cost $2.03 today, however it hovers at $8.50 or more.
Whether your retirement from the hectic life of running your shop is years away or just around the corner, inflation will exert a major influence on your future. Inflation makes it critically important that every dollar in your investment portfolio and retirement accounts be kept working for you around the clock. Making that happen is not as easy as it used to be.
Inflation can vary wildly from one year to the next. However, even the modest inflation rate of recent years takes a significant toll over time. After 10 years of inflation at 2 percent, a dollar bill is today worth 82 cents, and inflation lately has been running significantly higher than 2 percent.
Asset allocation
There is a basic rule of thumb for personal investing: Stocks carry the most risk, but provide the best long-term return; bonds are less risky than stocks, but have a lower average return; cash provides the most safety for your principal, but its earnings may barely keep up with inflation.
Given your personal situation, carefully consider how to divide your assets among those three investment classes (it’s called asset allocation) to get the desired balance between risk and healthy returns.
A study by the market-data firm of Ibbotson Associates may help. The study provides average annual returns with compounding and reinvestment of dividends from the 80-year period between 1926 to 2005.
The highest return (12.6 percent) came from small-company stocks (typical of the smallest 20 percent traded on the NYSE). The next highest return (10.4 percent) came from large-company stocks. Long-term government bonds yielded 5.5 percent and last place in the yield race was cash (3.7 percent) represented by the 30-day Treasury bill.
All of these figures are before inflation, which averaged 3 percent during the period. To get the “real” return, of course, we must subtract inflation’s 3 percent from the above figures.
If we subtract inflation’s 3 percent from cash’s 3.7 percent return, the real return is only 0.7 percent—close to no return at all. At the other end of the scale, we have a real return of 9.6 percent from small-company stocks and 7.4 percent from large-company stocks. Bonds fell in the middle with a real return of 2.5 percent.
It’s easy to see why financial advisors recommend substantial investments in stocks for any portfolio. For younger investors with a 30- or 40-year window before retirement, some advisors might recommend allocating as much as 80 percent, or even more, in stock investments. Investors nearing or already in retirement may be advised to reverse that figure with 80 percent in bonds and cash and only 20 percent in equities.
With the management of your investments in mind, how much can you depend on the long-term averages to repeat during your investment window? That, of course, is where the rub comes in.
The charts that map the ups and downs of the market over the years suggest that you have a good chance of matching the average figures over periods of 10 years or more. However, the results during shorter periods can differ drastically from the averages. Down periods in the market lasting two, three or more consecutive years are not uncommon.
Volatility in the market’s behavior suggests that younger investors can safely and profitably ride out market extremes while older investors nearing retirement are advised to allocate their assets toward the more conservative and stable investments such as bonds. With average life spans increasing to the point where 90-year-olds are no longer a rarity, keeping up with inflation is a necessity for just about everyone.
Other factors influencing the way you allocate your assets are your personal tolerance for risk and whether you have a solid retirement plan to supplement Social Security must be taken into consideration.
Many financial planners estimate that you will need 80 percent of your pre-retirement income to maintain your lifestyle after retirement. If your earnings are, say, $80,000 per year just before you retire, you will need $64,000 in retirement income to retire in the style to which you have become accustomed, according to one popular school of thought.
However, Walt Woerheide, Ph.D., vice president of academic affairs, The American College, believes that most people experience a significant drop in expenses when they retire. “Chances are your mortgage will be paid off, you’ll no longer need to put aside money for savings and your children will have finished college.”
Certified financial planner Carl J. Kunhardt disagrees. “We’re finding that clients are spending essentially the same in retirement as before. It’s what they are spending it on that changes.”
There’s no single model for estimating financial needs in retirement and more problematic, perhaps, is that some of the popular formulas for estimating required retirement income fail to consider inflation. That’s why you must.
The Charles Schwab brokerage has published a retirement planning rule-of-thumb that takes clear notice of inflation’s effects. It suggests that you will need $230,000 in retirement savings in today’s dollars to provide $1,000 in monthly income during retirement. If you want to add $5,000 per month to your Social Security income, you would need $1,150,000 in retirement savings and investments—in today’s dollars.
The key phrase in the Schwab formula is “in today’s dollars.” If, for example, your retirement is 10 years off, you must increase the $230,000 in the formula to allow for the effects of inflation for those 10 years.
Obviously, no one can predict the exact inflation rate in advance; all we can do is estimate. Even if you assume a modest inflation rate of about 2.5 percent over the next 10 years, that $1,150,000 in today’s dollars will be about $1,472,096 in 2017 dollars.
Compensating for retirement’s effects
Financial consultant, Ingrid K. Lamb, Chesapeake Beach, Md., points out that Social Security and some private pensions are adjusted annually to help counteract the effects of inflation. However, retirees depending on investments for a significant part of their income may find that’s not enough. “One way of compensating for inflation,” she says, “is to invest part of your portfolio in dividend paying stocks with a history of steady dividend increases.”
Maury Randall, professor of finance at Rider University, Lawrenceville, N.J., agrees that every retirement portfolio should contain some stocks as a hedge against inflation. “Another method of protecting yourself is investment in inflation-indexed treasury securities (TIPS). These Treasury bonds provide a return based on the current rate of inflation,” he says. “So when inflation rises, you’ll get a higher interest rate.”
So where should a person start? Young people might allocate 75 percent (or even 80 percent) of their holdings in stocks, 20 percent in bonds and 5 percent in cash such as money market accounts or CDs.
With each successive decade, experts suggest a shift in asset allocation toward a “safer” balance between risk and expected return. In the very latest years, a conservative investor might forego investments in equities entirely in favor of bonds and cash equivalents. It’s that period in between those years that calls for careful consideration of the factors that affect your personal investment style.
Finally, perhaps the toughest decision of all is where to invest that portion of your portfolio dedicated to stocks. In my view, choosing individual companies in which to invest is not a job for the casual investor. Unless you’re willing to study reams of statistical data and spend hours poring over annual reports, you should consider the advantages of investing in mutual funds. That way, you leave the job of picking companies up to full-time professionals. If you’re satisfied with the likelihood of matching the overall performance of the market, sticking with index funds may be your best choice.Whatever form your personal retirement plan takes, make certain that you take the inevitable effects of inflation into account.
For TIPS information, visit TreasuryDirect, The U.S. Treasury’s Web site at http://www.savingsbonds.gov/.
Information in this article is provided for educational and reference purposes only. It is not intended to provide specific advice or individual recommendations. Consult an accountant or tax advisor for advice regarding your particular situation. TR
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