The following is another guest post from Free Money Finance reader Rod Ferguson.
Retirement is every working person’s goal - specifically, to retire as early as possible and with as much wealth as possible. Dreams of living a carefree life, doing what you want without the need to work a daily job to survive, to travel, to volunteer or to just catch up on all that reading you’ve been promising yourself over the last 20 years.
Unfortunately, not everyone plans for retirement. Even more unfortunately, those that do might be planning ineffectively if they do not take into account inflation - when living on a fixed or semi-fixed income, inflation has a profound impact on your retirement quality of life.
Merriam-Webster defines inflation as, "A continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services." Basically, inflation makes goods and services more expensive and decreases the value of your money. When you are working, your wages generally rise as the costs of goods and services increase. Your earnings try to "keep pace with inflation", so nominal inflation is not generally an issue. However, when you are living off savings, inflation literally robs you of wealth as it destroys your purchasing power.
Most people underestimate the impact inflation will have on their retirement plans. Even with the official figures (known as the Consumer Price Index, or CPI) showing low inflation rates, through the magic of compounding, even 3% over 20 years nearly triples your savings needs.
Doing the math
One thing to remember when calculating your yearly retirement needs is to factor a) your expected lifespan, b) your standard of living and c) the age at which you wish to retire. For example, if you are currently 35 years old, male, anticipate needing $35,000 a year in today’s dollars to survive and wish to retire at 55, you would need approximately $700,000 to retire, not factoring in inflation. Starting now, and assuming an average rate of return of 6%, you’d need to start saving about $750 per pay period ($1,500 a month) to reach that goal (this is assuming no pension, no Social Security, etc. Just savings.) Now, if you add that 3% inflation over the same period of time, your total would be in the ballpark of $2.1 million dollars and you’d need to start saving – today – $2,300 per pay period or just under $4,600 per month. Add one percent to that inflation rate, and your numbers are now at $3.3 million at $3,500 per pay period or just over $7,000 per month.
Now, before you have a heart attack, the example above is a pretty aggressive retirement plan, with only 20 years of savings, a life expectancy of 75 years (or 20 years of retirement) and a somewhat low rate of return. These numbers can be managed by extending your retirement age to 60, 65, 67 or whatever and by including things like Social Security, extra income streams, etc. And, the good news about Social Security and some pension programs (though fewer as time goes on) will adjust your benefit for inflation. The bad news is that the CPI is grossly underestimated; you will require far more money to support your lifestyle in the future.
How CPI is measured
The Consumer Price Index is a measure of the average change in prices paid by consumers for a fixed market basket of goods and services. Started after WWI, the CPI was used to assist businesses and laborers in tracking cost of living adjustments to wages. The statistic served its purpose well until the 1980’s, when Michael Boskin and Alan Greenspan proposed changes to the calculation; no longer should the CPI be based on like-for-like calculations, but should instead be calculated with equivalencies. Their argument was that when something became too expensive, then the public would substitute something with a lower cost. A popular example of this is the “Steak to Hamburger” analogy: when steak gets too expensive, the consumer would substitute hamburger for the steak. The inflation measure then should reflect the costs tied to buying hamburger versus steak, instead of steak versus steak. The old system told you how much you had to increase your income in order to keep buying steak whereas the new system assumes you will stop eating steak and start eating hamburger. This keeps the CPI low (hamburger costs less than steak) but doesn’t really reflect inflation. Additionally, the CPI is now weighted geometrically: things rising in price are given lower “weight” than things decreasing in price. The logic behind this is that when prices decline, consumers stockpile more of the lower cost goods than the higher cost goods.
In 1975, the CPI was first used to calculate payment increases in Social Security (prior to this, Congress needed to approve benefit hikes.) Since this began, it has been in the government's best interests to keep inflation low. Since the government really can't control inflation, it has decided to control the inflation calculator. A recent best guess on Social Security estimate that payments should be roughly 50% higher than they actually are today and the disparity is growing. When planning for retirement, it really isn't such a bad thing to discount Social Security payments; you'll have no idea what they will actually be and what purchasing power that amount will have.
What does this mean?
Inflation is much greater than is currently being reported; current CPI is stated at about 4%. Using the non-weighted pre-Boskin/Greenspan model, CPI is close to 12%. Which feels more accurate to you? When calculating your retirement numbers, it would be advisable to run them with both the official CPI and the older model calculations; if you can plan using both, you have a much less chance to be “caught unawares” once your retirement approaches – it’s better to have more then you need than not enough. By accepting the official inflation rate as the standard, people may be shortchanging their retirement and they won’t realize it until it’s too late.
I have come to trust the pre-Boskin model much more than the post-Boskin model for calculating inflation. I agree that there is some logic behind the move, but I believe that the model should have been scrapped and completely re-worked rather than modified. People had come to rely on the CPI for generations; by making modifications without changing the model, the new system was able to “borrow” that trust, even though the model has become much less accurate in calculating inflation. People may buy hamburger more than steak when steak is more expensive, but to take this phenomenon as proof that prices aren’t rising is deceitful; are we still going to report inflation as low when people start buying dog food because they can no longer afford hamburger?
As I stated above, you can create a retirement plan by manipulating the categories surrounding retirement. One way to plan is to save lots of money. Another way is to reduce your retirement years. Another is to reduce your expected monetary needs; this is the avenue that is the most inflation-independent. By owning your own home versus renting, any inflation will only impact your taxes and maintenance. By learning a few farming skills (growing, harvesting, storing), you can grow a reasonably sized garden that can greatly reduce your food cost. By investing in renewable or “green” power technologies (solar, hydro, geothermal), you can reduce your dependence, and therefore cost, for energy. Reducing your overhead will stretch your retirement dollar much more than saving more of them.