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The Impact of Time and Inflation on Financial Plans
Preparing for retirement requires careful planning. What you need to consider is the impact of inflation on the expected cash flows, i.e. the money that you expect to receive from a retirement plan, once you hit the retirement age. In fact, inflation may significantly increase the future prices of basic goods and services. See our video here.
For example, assume that you currently spend $45,000 per year on basic needs, such as food, clothing, rent or mortgage, credit card debt, and insurance. At the current inflation rate of 2.2%, in 20 years you will need $68,042 to cover those basic needs. Now imagine that the inflation rate is 5.0% per year for 20 years. You will need $113,713 per year. If you investments and income do not also keep up with inflation, your purchasing power will significantly be reduced over time. When you work on retirement planning, it is important to consider inflation and what assets and income move with inflation and which are stagnant. These assumptions will greatly impact the outcome.
The Power of Inflation
Over that past 20 years, annual inflation has averaged approximately 2.15%. However, in the 1980’s it reached 13.5%. The difference may not be great from year to year but over 20 or 30 years it can be huge. With people retiring in their 60s and living into their 90s, the inflation risk is a critical consideration.
Here are some examples of how things change in time. In 1917, one hundred years ago:
- The average life expectancy was 47 years old.
- The five main causes of death at that time were diarrhea, heart disease, pneumonia and influenza, stroke, and tuberculosis.
- Only 14% percent of the homes had a bathtub.
- 8% had a telephone.
- At least 95% of births took place at home.
- There were only 8,000 cars all over the United States and the fuel for these cars was sold in drug stores only.
- Women did not wash their hair more than once a month, using egg yolks for shampoo.
- Marijuana, heroin, and morphine were sold over the counter at the local drugstores for medical purposes.
- Sugar was four cents a pound, eggs were 14 cents a dozen, and coffee was 15 cents a pound.
- The average wage in the United States in 1917 was 22 cents per hour. An average worker made between $200 and $400 per year.
- For higher-scale professions, such as doctors, accountants, and mechanical engineers, the average annual income ranged between $2,000 and $4,000,
- 90% of all doctors did not have a college education.
- Only 6% of all Americans had a high school degree.
- 230 murders were reported in the entire US during the entire year.
The Impact of Inflation on Retirement Plans
Inflation is measured using the consumer price index (CPI). This measures the change in price for a general basket of good. However, that basket of goods does not necessarily reflect the inflation that each person will experience. For example, someone who uses more medicine, gas, college tuition, or rent than the CPI basket of goods could experience a rate of inflation different than the CPI.
Inflation has an significant impact on financial plans. Your investment portfolio should at least keep up with the rate of inflation to maintain its buying power. Currently, at most banks interest rates are below the rate of inflation. Your money in a bank is losing buying power each day.