How Deflation Affects Your Retirement
The words “deflation” and “retirement” are seldom uttered in the same sentence – or even in the same context. There are several good reasons for this.
History and Policy Make Deflation an Unlikely Threat
Deflation is the opposite of inflation. Instead of a rise in the general level of prices, deflation denotes a decline in the general level of prices. Sizable deflations occurred occasionally in the 19th century but have been scarcer than hen’s teeth since then. Just as inflation results from increases in the supply of money, deflations are associated with decreases in the money supply.
The twentieth century coincided roughly with the advent of central banking. Central banks’ ostensible purpose was to stabilize the level of economic activity by controlling the supply of money and credit. 19th-century deflations coincided with economic recessions, or “panics” as they then were called. The financial manifestation of panics was the failure of banks. Under a system of fractional reserve banking, bank failures caused contraction of the money supply by some multiple of the bank deposits lost in the failure.
Central bankers have long viewed the money-supply contraction and resulting deflation as the proximate cause of the accompanying recession. They view it as their mission to prevent deflation at all costs. This belief has imparted an inflationary bias to economic policy, since the determination to avoid deflation absolutely means that error can occur only on the side of inflation, not in the other direction. (By way of comparison, the general level of prices was about the same at the end of the 19th century as at the beginning. The deflationary episodes were roughly offset by wartime inflation, caused by the printing of money to finance the wars. Increases in productivity, which would otherwise tend to cause prices to decline gently from year to year, were offset by new discoveries of gold and silver, which were the monetary backing for the money supply.)
Retirees Have Little Reason to Fear Deflation
The unlikelihood of deflation is one reason why its effects are seldom discussed in retirement finance or elsewhere. Another reason is more practical. Inflation tends to benefit debtors, who are able to repay debt in money whose purchasing power has decreased. Correspondingly, it harms creditors, whose repayment is worth less in real terms than its nominal value. Classically, retirees hold wealth in the form of fixed-income assets, such as bonds and annuities. They receive pensions whose nominal value is fixed. Thus, inflation is a deadly threat to them, and copious attention is paid to possible protective measures against it.
Deflation would – if actually experienced – benefit retirees because it is the mirror image of inflation. Nominal value payments from debt securities and pension funds would increase in purchasing power. Even if deflation caused a recession, this would not harm retirees per se. After all, they have no jobs to lose and their wealth is largely shifted away from growth assets, such as stocks, whose value would fall in recession. Since deflation would be a boon rather than a curse to retirees, there is no need to take preventive measures or plan elaborate strategies to guard against it.
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Some Modest Caveats
Given the prevalence of central banking and its mindset, deflation seems unlikely to occur. Nonetheless, a few brief modifications of the conventional thinking just outlined are probably in order.
The thesis that a deflationary recession could only help, not harm, retirees depends to some extent on their asset allocation. Recent increases in life expectancy have made it advisable for retirees to increase their exposure to growth assets, such as equity shares. In turn, this might make their wealth vulnerable to deflation. The best prophylactic for this is the standard one: diversify equity holdings and limit their exposure in the portfolio. Indeed, the very makeup of the retiree’s portfolio is already well-suited to this, since losses in the equity portion would be counterbalanced by the deflationary gains on the dominant fixed-income portion.
A more likely scenario for deflation would be as the aftermath of a systemic financial meltdown, perhaps triggered by hyperinflation and government-debt default. Trying to insure against such an overwhelming catastrophe is a little like trying to protect against collision with an asteroid or the death of the sun. Even so, ownership of gold rates to provide some minimal degree of protection against global economic cataclysm. Because gold doesn’t earn interest and has only a limited potential for growth, it should comprise only a small fraction of a retiree’s portfolio. 10% would ordinarily be a generous allocation.
Deflation and retirement are seldom conjoined in financial discussion. Central-bank policymakers strive to avoid deflation at all costs. Deflation benefits creditors, which should make it a boon to retirees rather than a threat. Since it seems unlikely to happen and not destructive to retirees even if it does, conventional retirement planning tends to ignore it.
Increased life expectancy provides an incentive for retirees to increase their equity exposure. Conceivably, this might be a source of discomfort in a deflation. Such protection as seems both necessary and feasible can be gained from portfolio diversification, particularly ownership of gold.
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