How Inflation Impacts Your Retirement Savings

Inflation is traditionally defined as a concurrent increase in the prices of all or most goods. This is unlike ordinary circumstances, in which price increases for some goods are offset by decreases in others. A sustained inflation must be the result of an increase in the supply of money and/or credit by the monetary authorities. Price increases for one subset of goods tend to withdraw purchasing power from the pursuit of other goods, thus reducing prices for those other goods and keeping the general level of prices stable. Only an increase in the money supply can support simultaneous price increases for all or most goods.

It is axiomatic that inflation helps some groups of people and harms others. Retirees are the prototypical victim class of inflation. An understanding of how inflation impacts your retirement savings must begin with the mechanics of the process.

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Why and How Inflation Hurts Retirees

By definition, retirees are people who are finished working full-time and earning money. The income they live on comes from assets accumulated prior to retirement. As a first approximation, this income is fixed in size and cannot be augmented. (There may or may not be scope for increasing income through part-time work after retirement.)

An increase in the general level of prices reduces the purchasing power of people on fixed incomes. Ordinarily, people consume smaller amounts of goods whose prices have risen and larger amounts of substitute goods. When all or most prices are rising, substitution cannot compensate for the damage to real income caused by rising prices. All prices do not rise proportionately and consumers do the best they can by substituting toward the goods whose prices rise less, but consumer welfare is reduced nonetheless.

Every dollar of expenditure made subsequent to price increases is income to somebody. If all incomes rose proportionately to increases in prices, the cumulative effect would (approximately) net out to zero. Nothing like this actually occurs. Retirees get little or none of the income gains resulting from inflation. Consequently, they are hard hit by any significant inflation. (Other groups, notably debtors, gain from inflation.)

How Inflation Impacts Retirement Savings

Retirees receive income from their accumulated assets. Mostly, these are financial assets. It is useful to understand the effects of inflation on these assets.

  • Bonds – Bonds are fixed-income instruments because their coupon payments and interest are stipulated in the bond indenture contract. The value of the flat coupon payment is steadily eroded by inflation. This tends to drive down bond prices in the secondary market, thus reducing the wealth of bondholders. Recent issue of government bonds indexed to inflation is intended to address this problem. The market prices of these indexed bonds will rise to reflect expected future inflation, thus offsetting the effects of indexation. The bonds do, however, protect against unanticipated future inflation.
  • Annuities – The guaranteed lifelong payments made by this quintessential retirement investment are fixed by contract. Thus, inflation eats into their purchasing power. Since annuities are intended to provide income for life no matter how long-lived the annuitant, this is a serious problem. Until recently, inflation-indexed annuities were unknown in the U.S. In Europe and South America, however, “real” annuities (as inflation-indexed annuities are called) have been offered for years. This may be due to the prominence annuities enjoy in those countries as replacements for government-provided social insurance. Quite recently, two leading U.S. financial-service providers have begun offering real annuities as well. The true test of these instruments will be a worldwide inflation such as that of the 1970s. This may or may not be imminent.
  • Stocks and Mutual Funds – Decades ago, the conventional wisdom regarded stocks as an inflation hedge, because their prices were free to rise in tandem with prices. The 1970s cruelly shattered this illusion. Inflation distorts the structure of relative prices that enables securities analysts and traders to accurately value companies. In the 1970s, the U.S. stock market made no aggregate headway throughout the entire decade. Only when inflation was halted in the early 1980s did the market rebound into the greatest bull market in history.
  • Money Market Funds and Savings Accounts – Prior to 1979, the Federal Reserve’s Regulation Q prevented the payment of interest on bank demand deposits and severely restricted interest rates paid on savings. When short-term interest rates zoomed into double digits and approached 20%, these ceilings became completely untenable. Money market funds were created specifically to evade the interest-rate ceilings established by this regulation. Eventually, Regulation Q was repealed and financial institutions were allowed to raise short-term interest rates enough to compensate savers for the effects of inflation. The compensation tended to come “in arrears;” that is, after the inflation had already hit purchasing power of savers. Even so, deferred compensation beats none at all.

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Can Retirees Fight Inflation by Holding Real Assets?

During every inflation, there are assets whose prices or value rise more than the amount of the inflation. In the case of gold, this outcome is predictable. Real estate is another reliable beneficiary of inflation. Other cases, such as those involving particular collectibles, are less predictable. To what extent can retirees protect themselves by holding these assets?

This strategy can be compared to pushing down on a tightly-paced suitcase in an effort to close the lid. Pushing down in one area causes another area to bulge upward. The result is unlikely to be a comfortable fit.

Gold is an asset that can be relied upon to outpace the value of inflation. Unfortunately, retirees hold assets to take income from them and gold does not (directly) pay interest. If the retiree holds only a small fraction of the portfolio in gold, that leaves most assets unprotected. If the retiree sells gold when its price rises during inflation, that leaves the portfolio unprotected and the investor forced to buy more gold at inflated prices.

Most retirees hold real estate in the form of their home. This is indivisible and cannot be sold piecemeal. If it is rented out, a new dwelling must be found. Its equity can be tapped with home-equity loans or reverse mortgages but these have drawbacks as well as advantages. They are one-time, not ongoing, sources of retirement income. Undeveloped real estate is divisible but expensive to hold and does not bear interest.

The upshot is that a strategy of offsetting inflation via real-asset accumulation is difficult to implement. The most effective strategy is to go “all-in” by converting wholesale to gold, gambling on big capital gains when the inflation strikes. This is risky because it puts all retirement eggs in one basket by betting on financial catastrophe.

What Can Be Done About Inflation?

Two sorts of countermeasure can be taken against inflation. The first sort strives to undo or partially compensate for the effects of inflation. Foremost among these is indexation – the adjustment of contractual terms to increase payments to counterbalance the increase in the general level of prices.

The trend toward indexation began in the 1970s, when labor contracts began to include yearly wage-adjustment clauses. The clause would usually adjust wages and salaries upward by the percentage amount of increase in the Consumer Price Index (CPI). The idea was to increase incomes commensurate with the average percentage increase in prices, thus roughly counteracting the inflation.

Since retirees do not work, they have no wage or salary to increase. Instead, they have had to rely on measures such as the repeal of Regulation Q and the creation of money market funds, both of which were vastly popular with senior citizens in the early 1980s. It is only in the last decade or so that the financial instruments upon which retirees rely for income – bonds, annuities, etc. – have also been indexed for inflation.

Indexation is a highly imperfect solution to the problem of inflation. To the degree that the indexed financial instrument does what it is supposed to do, it becomes more valuable. This results in its price being bid up enough to offset the benefits of indexation. Only if inflation is more than anticipated do the benefits of financial indexation really come to the fore.

An Alternative Solution to the Problem of Inflation

By analogy, inflation can be compared to a disease. One way to attack the problem of inflation is to treat its effects, trying to completely reverse them if possible. This can be compared to treating the symptoms of a cold or the flu. An alternative approach is to prevent or end the inflation. This is analogous to preventing a disease through vaccination or other means, or stopping it cold through quarantine.

For centuries, governments treated inflation like a plague of locusts, coming out of nowhere for unknown reasons and departing just as mysteriously. Even today, it is common to see reportage or analysis stating that inflation is “quiet” or “non-threatening,” as though it were an outside force that would sleep if left lying but might suddenly erupt if disturbed. Governments find this attitude convenient. It conceals the fact that inflation is a monetary phenomenon that serves the ends of government policy by reducing the real value of government debt.

Since inflation is in reality a political problem, the only way to prevent it is political. A political constituency against inflation – the mirror image of the agricultural debtor class that favored the inflations of the eighteenth and nineteenth centuries – must coalesce. Retirees would form the backbone of such a class.

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