Your Job is Indexed for Inflation. Your Investments (Probably) Aren’t.

by Guest Contributor · 11 comments

Luckily for the workforce, wages/salaries tend to rise along with price levels. That is, people tend to get annual raises even without getting promoted. On the one hand, this is good. It makes it so that most people can maintain a relatively stable standard of living.

On the other hand, our annual raises have taught many of us that inflation is something we don’t have to worry about. We’ve been lulled into a false sense of security.

Uh oh.

I saved an article from Money magazine a few months ago in which the writer quoted a study stating the following:

  • If you’re 40 now, there’s a 55% chance you’ll live to be 85. In order to not run out of money by age 85, you’d have to have $2.5 million before you could retire.
  • If you’re 40 now, there’s a 36% chance you’ll live to be 90. In order to not run out of money by age 90, you’d have to have $3.6 million before you could retire.

That’s a lot of money! A couple thoughts:

  1. The study assumes you want to retire at age 65. I know plenty of people who plan to retire younger than 65. If that’s your plan as well, you’ll need even more money.
  2. For those of us younger than 40, our required amounts would be even higher.

It’s easy to underestimate the amount of money that we’ll need to have saved before we can retire. It’s easy to write off inflation as insignificant. Unfortunately, that’s a big mistake.

So what should we actually do in order to combat the power of a lifetime of inflation? Two things, I think:

  • Take the time to work out a reasonable estimate of how much you’re going to need in order to retire, based upon your personal information (spending level, age, etc.)
  • Come to terms with the fact that you’re going to need a heavy allocation to stocks in your portfolio (even after you’ve retired!) in order to stay ahead of inflation.

About the Author: Mike writes at The Oblivious Investor , where he regularly reminds readers to stick with stocks even when it’s tough. If you like this post, subscribe to his blog to read more.

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{ 11 comments… read them below or add one }

Rendell @ BrandlessBlog.com January 19, 2009 at 7:11 am

Hi,

Thanks for pointing that out.

It is likely most people would assume that by contributing to their retirement accounts or govt schemes, they would be able to live comfortably during their retirement (probably at 65). However studies have shown that human are outliving their ancestor every year. And since most of the insurance companies are using 100 years old as the top limit for their annuity plans, and as you point out the whole lot of us, below the age of 40 will be facing this longevity risk.

Naturally, strategies to hedge against inflation will be the of the most important things we need to out into our financial plan.

Rendell

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Mike P January 19, 2009 at 7:17 am

Hi Rendell.

“Studies have shown that humans are outliving their ancestors every year.” Exactly.

In so many ways, it’s a wonderful thing… We just have to make sure we’re ready to pay for it. :)

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marci January 19, 2009 at 7:31 am

Obviously those studies don’t take into account the people that are used to living frugally.
No way will it take that kind of money. As long as I let my principal sit, and just skim off the interest, I figure I can make it to 103 (my personal goal) on one heckova lot less than that.

And did the studies factor in social security, pensions, investment income into those figures, or are those figures cash only?

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Mike P January 19, 2009 at 7:36 am

Hi Marci, thanks for commenting. :)

Here are the assumptions made in the study:

1. Investor seeks to maintain a standard of living that would currently require $75,000. (I definitely agree with you here. My wife and I could live on significantly less than that.)

2. Inflation is 3% (This is actually a bit lower than I’d count on.)

3. Asset allocation is 60% stocks, 30% bonds, 10% cash. So–while a conservative asset allocation–it certainly assumes a significant amount of investment return.

4. No Social Security or Pension income.

5. Nothing at all is left to heirs.

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Manori Money January 19, 2009 at 9:48 am

I think this a very good post for what we are going though these days. We def. need to plan our retirement/financial situation

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Mike @ TheThriftyLife January 19, 2009 at 1:15 pm

That is, people tend to get annual raises even without getting promoted. … On the other hand, our annual raises have taught many of us that inflation is something we don’t have to worry about. We’ve been lulled into a false sense of security.

Regarding raises – The people I work with are well aware of what they make and are often actively striving to do more and learn more to increase their earnings and earn their raises and bonuses. The time of the assumed/automatic raise is over and it has been for a while. Nothing is guaranteed, and today’s workers knows that – we FEEL IT.

I for one haven’t been lulled into a false sense of security. The truth is that if you felt secure and now aren’t, you probably weren’t paying attention to your finances well enough in the first place. Save, save, save and live the thrifty life.

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Chiko January 19, 2009 at 6:01 pm

My advice is, create a passive form of income that continues to increase overtime, that way you don’t have to worry too much about inflation. That is what I am currently working on right now. I am working to create a passive income stream of about $3,000 on a monthly basis.

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marci January 19, 2009 at 8:13 pm

Thanks for the clarification. I’d like to see what “they” think one needs to live on $20,000 per year. I do fine on that now – and once I get to SS and pensions will be living higher on the hog than I am now – so it should be very easy :)

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Sam January 20, 2009 at 7:57 am

What does the $2.5 and $3.6 million mean? How much money per year will that generate for you. I would like to know the assumptions they used to come up with those figures.

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Mike P January 20, 2009 at 10:17 am

@Chiko: As a business owner myself, I couldn’t agree more. Building passive income is an excellent way to prepare for retirement. (Or just to improve your standard of living right now.)

@Sam: See my above comment to Marci for all the assumptions mentioned in the study. (It explains the assumed asset allocation, but doesn’t give what expected returns they’re using. It does, however, say that the data is from T. Rowe Price, so I’d be willing to bet that it’s pretty good.)

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Hans Broesicke November 9, 2011 at 1:20 pm

It should be noted that the earlier you start saving/investing the greater chance you have of reaching your [early] retirement goals.

Starting at 25 vs. 35 has a dramatic effect on the net result. Starting at 18 vs. 35 is exponentially higher. The power of compounding. Banks know about it, so should you.

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