Prospective retirees need to plan ahead to prevent the erosion of their earnings power once they are off the clock.
With Valentine’s Day coming, I’m sure that you’re racking your brain for an appropriate gift for your sweetheart. Maybe you had such great foresight that you bought something a while ago and stashed it in anticipation.
Maybe you found a Valentine’s card a few years ago and now feel that it is the appropriate time to use it. Depending on when you bought that card, you might not only have been thoughtful, but perhaps even shrewd. The $1.75 that you would have paid for that card in 1990 would now set you back $4.75. A Houston financial planning friend developed a “cost of loving index” in 1990 and has tracked how inflation has affected various items since then. Inflation on Valentine’s cards has averaged more than 4 percent annually, still less than the more than over 5.5 percent a year inflation rate on first-run movies.
Inflation is the rust of financial planning. It eats away at our assets. It may be barely noticeable day to day, but over time we find huge holes in our cash flow. Think about it this way: A house that you bought for $175,000 in 1990 would now cost you $475,000 if it has appreciated as much as the cost of that Valentine’s card.
Inflation can be tricky in a number of ways. For Valentine’s Day, if you have been in your relationship long enough and the cost of California chardonnay gets too expensive, you may substitute it with Trader Joe’s Two-Buck Chuck (which has been chucked-up to $2.50 a bottle). But you probably won’t switch from your doctor to a shaman if your health care costs rise.
Clients sometimes think that they can combat inflation by reducing their costs in retirement. When clients are considering retirement lifestyle expenses, we don’t reduce them. We use an inflation factor to ensure that their spending keeps pace with rising costs, but we also recognize that those who retire in their 60s will still lead very active life styles. This means that they tend to travel more and spend more. We actually don’t typically see a reduction in client spending until they are in their early eighties. At that point, costs often drop because activity drops. Costs may go up if there are health care issues.
Cash flow is crucial
Understanding cash flow is an essential first step in any financial planning, but it is truly crucial for retirement planning. When a younger client comes in and wants to plan for their retirement decades away, we want to understand whether they want similar cash flow to today’s or reflect that their incomes and spending may rise over the next several years.
Has your lifestyle expanded from your 20s to your 40s? For those who are retiring in their 60s, we want to be sure that their spending can stay constant. People in retirement usually get too conservative with their portfolios too soon. We have had a number of people come to us in their early 70s who thought that they were fine with their retirement savings in bonds or annuities. Unfortunately, when interest rates dropped over the last several years, so did their income — even though principal may have stayed intact. If they owned a 5 percent bond, that bond when it’s matured and reinvested will pay 3 percent. So they suffered a 40 percent loss of income — not even considering inflation! They are now trying to play catch-up in investments that may be too risky for them.
Despite the alarmists who fear that the Federal Reserve’s easing efforts will lead us to hyperinflation, we won’t experience anything close to what Bill Bryson describes in his book “One Summer: America, 1927.” Bryson recounts how the “French, exasperated with Germany’s failure to keep up with reparations payments, had seized the Ruhr, Germany’s industrial heartland. The result was dizzying hyperinflation. The mark, which had traded at about 4 to the dollar before the war, now shot up to 600,000 to the dollar. By summer, the exchange rate was 630 billion marks to the dollar and inflation was so rampant that prices were doubling daily, sometimes hourly.’’
But even if inflation is 3.5 percent a year, we need to prepare for it. These are the steps to take:
Determine a reasonable range for your working time horizon. Also, determine whether it is likely that you will bring in income when you are no longer working full time in your regular occupation. Ancillary income can have a big effect on the positioning of your investments as well as your dependence on them once they make up the bulk of your spending.
Develop an understanding of what your cash flow needs will be when you retire. Try to determine ways to drive down your fixed costs (the mortgage, for example) as much as possible. The reason? If investments go through a difficult period, you can adjust your discretionary spending by not taking a trip or delaying a car purchase. But fixed costs live on.
Create an investment plan that matches your expected future spending needs and your risk tolerance. The only investments that keep pace with inflation are stocks. Bonds are important because they provide income and shelter from the stock market’s volatility, but they don’t provide inflation protection. If you hate stocks, your only real choices are to work longer or save more. Accepting the market ups and downs will allow you to send a dozen long-stemmed roses in the future rather than simply an e-bouquet.
Ross Levin is the founding principal of Accredited Investors Inc. in Edina. His Gains & Losses column appears twice a month. His e-mail is firstname.lastname@example.org.