Stealth Inflation For Retirees

While the official numbers on inflation show that there isn't any, retired investors are subject to a form of stealth inflation. As interest rates have plummeted, the cost of producing retirement income has skyrocketed.

Here's what I mean:

• In January of 2007 (just before the financial markets started to unwind), a 10-year U.S. Treasury bond paid 4.76 percent interest. So if you wanted to produce $50,000 of risk-free income in retirement, it would cost you about $1,050,000. Basically, you take $1,050,000 of your retirement money, and you buy U.S. Treasury bonds. The interest from those bonds provides you with $50,000 of income to spend.
• But today, as a result of the financial crisis, the interest rate on the 10-year U.S. Treasury bond has dropped to 3.39 percent as of the end of October. That means if you want to produce $50,000 of retirement income, you need about $1,475,000 of assets. Wow, that's about 40 percent more than before the crisis.
• This means the cost of producing retirement income has in one sense jumped 40% in the last few years. But that "stealth" inflation for retirees isn't picked up anywhere in our government statistics.

A Second Look. Another way to think about it is to consider how much income your $1,050,000 of retirement savings would buy today. Again, in January of 2007, it provided you with $50,000 of income to spend. Today, with interest rates lower, you would only have $35,600 of income.

• But, the things you could have bought for $50,000 in 2007 haven't declined to $35,000. Basically, what you could have bought in 2007 with $50,000 still costs about $50,000. Thus, your standard of living has declined, which is essentially the same result you would have gotten from "official" inflation.

What To Do About It. Because interest rates can swing wildly depending on the economic cycle (and thus change the value of your income stream), you should consider spreading your money around so that you have less volatility in your cash flow.

• Consider that if you bought a 10-year bond in 2007 at 4.76% it would still be paying you that interest even though current rates have fallen.
• Although that 10-year bond rate in 2007 didn't look so attractive given that money markets were paying about 4 percent, it turned out it was a good deal.

The point is you can't predict the future course of interest rates. Thus, it makes sense to secure interest payments by laddering your fixed income holdings so that you have some shorter and longer term holdings.

• With the short term holdings, you don't get paid as much, but you get your money back faster, so you can reinvest at higher rates if we have inflation or an improving economy.
• With intermediate and longer term holdings, you get more income to live on today, but can't respond as easily to changes if interest rates rise.
• This simple discipline of laddering your holdings tends to be a very effective way to manage interest rate risk (or the cost of producing retirement income) because it provides you with a balance between a meaningful amount of income today and the ability to adapt in the future.
• You'll have to decide on the appropriate mix depending on your income needs.

Stocks. Don't forget about the income component that comes from stocks in the form of dividends. While some high profile companies cut their dividends, many well established global brands have continued to pay their dividends and even increased them over the last year. These increases can help offset the effects of official or unofficial inflation.

Annuities. With all the volatility in the financial markets, you might be considering buying an immediate annuity to guarantee a portion of your retirement income. Well, insurance companies are also affected by the interest rate environment.

• For instance, if you use $1,000,000 to buy an immediate annuity when interest rates are at 3.39 percent, you'll get a lot less income in retirement than if you buy it when interest rates are at 5 percent. You see, when rates are low, the insurance company looks out into the future and assumes it can't earn as much on your money, so it's going to pay you less income for every dollar you invest.
• Thus, just like with the bond example, it will cost you much more money to secure your retirement income when rates are low.
• If you're considering immediate annuities as a source of income, think about spreading your purchases out over several years so that you have some opportunity to benefit from potentially higher rates in the future.

Bottom line. The financial crisis may produce inflation in ways that aren't captured by government statistics. To protect the value of your retirement income stream, make sure you diversify your income sources.

As with all financial matters, consult your individual financial advisor prior to making any financial decisions.

Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my upcoming book Your Money Ratios: 8 Simple Tools For Financial Security, available for pre-order at amazon.com

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