How Inflation Works
Inflation is a term that describes just the opposite of what it sounds like it is supposed to. Every year, the money you make will buy a little less per dollar than it did a year ago. What is inflated is the number of dollars a person has to generate to be able to preserve the same buying power year after year. The percentage that a dollar is reduce by is calculated by the Consumer Price Index (CPI) which is a measure of the average change in prices, from one year to the next, in a market basket of goods and services (i.e., a loaf of bread, new tires, shoes, a tune up for your car, etc.).
For example, in the year 2001 that market basket of goods and services cost, say $1000. In 2002 that same grouping of stuff cost $1027.90 - the percentage increase is 2.79%. If you didn't get at least a 2.79% raise in pay, you've lost money.
Now the effect of inflation is cumulative as well. Each year the rate of inflation has to take into account the reductions in the dollar's buying power from previous years. It all depends on when you start.
|Suppose you were a new college professor
who begain her career in the 1983-84
Your Salary was $20,000 in 1983.
Therefore, your salary, if it kept up with
Of course, the buying power of $20,000 in 1983 dollars isn't much - it'd actually buy a standard of living equivalent to have that of the average American family (which is about $40,000 per year and includes no savings for retirement).
In order to save money for the future (home buying, college for the kiddies, retirement, etc.) your salary has to do better than inflation. Ginger Applegarth has some thoughts on that subject:
Understanding the Impact of Inflation By Ginger Applegarth*
Inflation is essentially dead so you donít have to worry about it anymore,
After all, the nationís consumer price index -- the most commonly used index to track inflation -- has hovered below 4% for the past five years.
Your shrinking dollar
Letís put this theory to a test. If you stuffed $1,000 into your bedroom mattress today and didnít pull it out for 20 years, how much do you think that $1,000 would be worth? That $1,000 would have shrunk to todayís equivalent of $456.
This shows why you must plan your retirement strategy to compensate and overcome the effects of inflation.
Inflation itself is a tough concept to grasp, because we have so many ways to measure it. A simple definition of inflation is that it occurs, in part, when demand exceeds supply.
Here's how inflation works: Assume all the adults in your town or city have a lot of money in their pockets and they all want to buy large screen televisions. There probably arenít enough big-screen TVs for everybody, so the manufacturers, distributors and retailers raise their prices to make more money and weed out those people who arenít willing to pay the extra money. The price is driven up and the buyers must pay more than they would have if demand for the televisions had not exceeded supply.
Donít ignore inflation
Good financial planning must always take inflation into account. If you disregard inflation, youíll probably be more conservative in your investing and put more of your money in fixed-income investments because the return is guaranteed.
A 5% return may be just fine for you and you have also avoided market risk (the risk that the price decreases). If you take inflation into account, however, and there is 4% inflation, your actual return is only 1%. Due to inflation, each dollar's purchasing power will be less each year.
That nice retirement nest egg you have calculated may look fine in today's dollars but will have much less purchasing power when the time comes to draw on it. So if youíve calculated that youíll have $25,000 for your yearlyretirement income, that figure may look fine if thatís what youíre living on right now. The fact is, however, you may look fine but youíre going to be in deep trouble. You may actually need $50,000 to maintain today's standard of living in the year you retire, and that amount will increase every year.
Planning for inflation in your savings
So, how do you plan for inflation? First, recognize that itís here to stay. Yes,the horrors of double-digit inflation from the late 1970s have passed, but inflation has not gone away. The Federal Reserve, the chief government body charged with monitoring the health of the U.S. economy, still considers the threat of inflation its number one nemesis.
Inflation varies year to year, but it is safe to assume 4%. If you already have all the money you need for retirement, all youíve got to do to keep pace is to find some investment vehicles, such as government bonds or money-market accounts, that pay annual returns of 4%.
But if youíre like the rest of us, you donít have enough for retirement. Most people are a long way from their dreams. If youíre in this category, you must invest in things that pay returns greater than the inflation rate to make up the shortfall. You must also try to save as much as you can each year to further cut the shortfall.
Reduce your standard of living
You may be assuming that your standard of living will increase over time until you retire. With inflation eroding the purchasing power of each dollar, think again about increasing your standard of living. You will have a much better chance of achieving your retirement goal if you maintain (or even reduce) today's standard of living and save as much as you can.
If youíre still young enough that your retirement strategy can involve long-term investing (10 years or more), most of your money should be in the stock market. Unless you really know your stocks, your best bet probably will be in mutual funds in traditionally higher yielding funds, such as growth, income or index funds.
Fixed-income investments wonít beat inflation
Fixed-income investments like certificates of deposit or money-market accounts will barely beat inflation over time. Because youíre investing for the long term, donít worry about market risk, because it doesn't matter if your portfolioís value rises and falls at times. The price of your stock or mutual fund only matters when you sell that particular investment.
Keep in mind that once you reach retirement, inflation will continue and youíre likely to live 20 years or more beyond retirement age. Any fixed monthly income benefit youíve set yourself up to receive will decrease in real dollars with each year because of inflation, so youíll need to rely on other investments as time goes forward.
Set your retirement plan based on the assumption that youíll live to at least age 85 and that your expenses will rise each year. If youíre married, you should plan your strategy based on the assumption that one of you will live to age 90.
The worst situation to be in is to have outlived your money, and inflation is the surest reason why this may happen. The problem with inflation is that it creates illusions -- the dollar bill that youíre holding in your hand today will be worth less tomorrow.
Good retirement planning must include inflation, both before and after
retirement. The worst that can happen is that you overestimate inflation
and end up with more money than you need. Your heirs will thank you.
*Ginger Applegarth is the Boston Stock Exchange reporter for Bostonís WBZ-TV and co-host of ďLive Money,Ē a weekday radio talk show on Bostonís ďBusiness 1060Ē WBIX-AM. A certified financial planner, she is also president of Applegarth Advisory Group, Inc., a financial advisory and media company. She has written three books including Wake Up and Smell the Money, published by Viking. She is a former contributing correspondent for CNBC's The Money Club and NBC's The Today Show and is a former contributing editor for Worth magazine. Her Web site, ApplegarthAdvice.com, offers a daily financial newsletter, commentary, tips and articles. She lives in the Boston area.
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