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Inflation and Retirement Planning? February 19, 2010

Posted by shaferfinancial in Finance.
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There is no more misunderstood part of retirement planning than effects of inflation.  Financial planners use it to impress their clients [victims?] with how much money they can save over 30-40 years.  Retirees mess up by taking out too much money in the first few years of retirement not accounting for it.  Savers, fail to increase their savings enough to deal with.  Frankly, the way around it is fairly simple but it does require you to understand a few things.

First, when we talk about inflation we are talking about is the general tendency for what you pay for the things you need to live to go up.  To correctly account for this effect, you need to own assets that also go up in value along with all these things you need to purchase.  Most financial planners take a wrong step right from the start.  They assume you can insulate yourself from this by not buying stuff, especially the big stuff like housing.  They assume if you own your own home you are insulated and suggest having it paid off as soon as possible.  But, that doesn’t insulate you at all.  Home ownership if very inflation susceptible.  You might not have a mortgage, but what about taxes, insurance, repairs, condo fees [or the things condo fees buy for the owner].  If you have to put a new roof on or buy a new air conditioner you will feel the effect of inflation.  Anyone that owns a house understands the constant repairs needed to keep a house in good order.

The second mistake is to have people in mutual funds.  Mutual funds do not correlate very well with inflation.  When inflation is raging, many times the stock market is dropping.  So just at the time retirees need to increase the amount of income the value of their assets are dropping; not a good combination as it destroys future withdrawals.

What is the easy fix?  Own income producing assets like real estate and dividend producing stocks.  This disentangles the retiree from the asset value and allows them to benefit from increased income.  Inflation pushed up rents over time.  It also pushed up dividends paid by companies over time.  So inflation will push up income for those involved in these assets.

Now, it is probably not a great idea to try to start to learn about ownership of these assets after you retire [but you can if need be], instead begin accumulating earlier so by the time you retiree you have a portfolio of well positioned income producing assets that have produced increasing incomes for you.  Quality assets will continue to do well over non-quality assets.  And if there is a material change, you will have the experience to make the proper adjustments.

Finally, if you had purchased an equity indexed universal life insurance policy from me, it would have been structured to account for inflation and that along with its natural abilities to avoid negative returns would stand you in good stead to have a glorious retirement!

One more outlandish comment needs to be made.  Since I live in an area with lots of retirees, I see the common issues they have.  Probably the biggest issue I see is that they try to stay in their homes well beyond what they should.  Nothing worst than seeing a home slowly destroyed from lack of maintenance [not lack of caring] because the owner can’t do it and won’t or can’t afford to have someone else do it.  Sell that home when your health starts to fail and move into either an apartment [senior is best] or a multiple use retirement community that has assisted living, nursing home and other amenities for seniors.  Better yet, sell that house before your health fails and enjoy what years you have left not worrying about maintenance, lawn care, re taxes and insurance!

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1. Jim - February 20, 2010

Dave,

Can you please expound a bit on the IUL policy being structured to
account for inflation? Is this through some sort of rider? And how much
protection can one get in an IUL from really hyper inflation, say 15% or more annually like we saw in the 70s? (I’ve been reading Stephen Leeb lately who is one of those guys predicting bigtime inflation in the coming years)
Thanks

2. shaferfinancial - February 21, 2010

First I deal with the inflation issue. The 1970s were indeed inflationary times.
1973 6.16%
1974 11.03%
1975 9.2% and then later in the decade
1979 11.22%
1980 13.58%
1981 10.35%

Generally economists tend to look at the 1960s for evidence of why and come up with three reasons [possibly 4].
1. Unemployment in the 1960s was sustained below 4%
2. Wages increases averaged 6%
3. Price shock [oil,food,mortgage rates]
4. Nixon’s price controls and the lack of fed’s action

This of course makes sense, if you have more people working with more money in their hands you are ripe for price increases. Add the oil shock which effected the price of a huge variety of goods and you have the recipe for high inflation which wasn’t acted upon by the fed. Now do we have anything like that now? No, not even close at the current time. But we do have some issues that are inflationary like the ongoing war [wars are always found to be inflationary], potential oil spikes with peak oil, huge deficit spending.

I think the bottom line is current conditions are unlikely to start hyper-inflation. However, you might disagree, its just my opinion.

Now to the EIUL. After spikes in inflation there have been spikes in returns for markets, especially the S & P 500. Returns for the mid 1970s:
1975 37%
1976 24%
1980s:
1980 32%
1981 -5%
1982 21.5%
1983 22.5%
1984 6.2%
1985 31.7%
And right up to 2000 we saw remarkable returns.

So that tells us that inflation leads to increase returns from the large companies that make up the index.

The real problem is inputs that are not taking into consideration inflation. If you are saving the same $$ amount in 1970 as 1990 then you are trying to fit a circle into a square hole. You have to increase your input into EIULs as you go along or you are trying to live off of 1970s dollars in 2010. A more detailed post on this is coming on bawld guy this week and I will link it from my blog.

Remember, high inflation hurts savers most and borrowers least. Retirees are probably hurt most because they can’t increase their savings like workers. But you need to get that money at low rates like now. I would think that now is a good time to buy investment real estate and other income producing assets. Take MMP for example. They pay a dividend [6.5% at today’s price]. But 40% of their income is from tariffs when they transport oil products. Now there is a little demand effect, but the more important consideration is that tariffs are priced by the federal government and go up as inflation goes up. Just last year it was raised 7.5%! So owning income producing assets is the most important consideration. As to EIULs, they will benefit at the end of the inflationary cycle because companies can charge more for goods and service. If you saw an inflationary time coming on the most important thing to do would be to make sure if you are planning on distribution from the EIUL to use wash loans to avoid the high interest rates that occur during inflationary periods!

Products that have riders for inflation protection do not make sense. They are costly [they have to be to cover the risk]. I wouldn’t advise them. Plan for inflation accordingly. Increase your savings during inflationary times.

As to Leeb, he has turned into a big pusher of gold companies stock and gold. He has some good ideas about other commodities that actually have an industrial use and TIPS, but gotta say he has been very wrong lately. In July of 2009 he stated the market was going down at S & P 500 level of 880. It is now 1100 a +25% move since his call. He has said that late 2010 we shall have 15% inflation and 25% in 2012-2013. The last quarter of 2009 was actually -, so he has a way to go to get to 15% in a year. Not saying I am a great prognosticator [I learned it doesn’t pay to try] but be careful of following any person making claims of their ability to see into the future! By the way his call on Ivanhoe Mines is interesting. Some good + movement over the last year, but lots of variability! But beware of investments that are currently losing money.

3. MachineGhost - March 22, 2010

> Generally economists tend to look at the 1960s for evidence of
> why and come up with three reasons [possibly 4].
> 1. Unemployment in the 1960s was sustained below 4%
> 2. Wages increases averaged 6%
> 3. Price shock [oil,food,mortgage rates]
> 4. Nixon’s price controls and the lack of fed’s action

None of the above. The big reason was the increased government borrowing and spending on the Great Society (Medicare, etc.) and Vietnam War programs. Constrained by the gold standard, something had to pop and it did in 1972 when Nixon delinked the dollar from international gold convertibility. Confusing cause and effect is what most economists tend to do. #1 and #2 are actually one of those tenants that seem to make perfectly rational sense on the surface, but upon closer inspection will show they don’t have the alleged effects at all.

That being said, the 70’s weren’t even remotely “hyperinflationary”. Get some perspective, Jim. Look at the Weimar Republic or Zimbabwe. Double digit inflation has nothing on those two.

As long as sovereign debt continues to implode around the world ala 1931, deflation will remain the forefront concern. Inflation will not return until the confidence in the world economy is restored which will induce people start selling off all their Treasuries in an evaporated market. That is at least half a decade off due to how long it will take to resolve the real estate crisis. Round two is already starting.

4. How to Insulate Yourself From Financial Failure » Lorena Dunn - April 2, 2011

[…] Inflation and Retirement Planning? Most financial planners take a wrong step right from the start. They assume you can insulate yourself from this by not buying stuff … Failure of 401Ks; IndyMac Bank Failure; Lehman … No Comments » […]


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