Is Inflation All In Your Head?
One of the big uncertainties for anyone planning to retire and live off of investment income is inflation. Working income tends to keep up with inflation, while investment income can be more limited. Some people build in a big margin of safety to allow for inflation, while others looks for things such as indexed pensions and annuities for protection. To make good plans you need to know what inflation will be, and no one knows this. There are always a few crackpots who claim that the real inflation rate is 15% and the real unemployment rate is 45%, but even using official data it can be hard to predict what will happen.
(Possibly the only inflation joke ever: The president of a mining company that produces iron calls of his counterpart at one of their major customers, a steel maker, and says, “Hey Bill, have I got some great news for you! You can tell your customers you’re raising prices this week! After all you just heard the cost of iron is going up.”)
A recent post on the Boomer & Echo blog highlights the unreliability of small appliances, but it also shows how their costs have fallen over time. Using a quick and inaccurate estimate, today’s equivalent of a VCR is 1/36 of the price that it would have been a few decades ago (even if you need to replace it more frequently). This applies to virtually all forms of electronics, and even other large purchases such as cars can be relatively cheap and reliable these days if you do a bit of research.
Which all leads to one question: do we really experience inflation, or do we just choose to buy more?
Data from the US shows that $100 in 1950 is worth $960 today. So someone who retired young in 1950 would have to have a large increase in their retirement income in order to keep up. For a slightly more common example, $100 in 1982 is worth $240 only 30 years later. Since most retirees go with fairly conservative investment options, it’s hard to produce a decent starting income let alone keep up with that kind of increase over a long period of time.
But the official inflation rate is based on what people tend to buy today. If you look at the houses, cars, and kitchen appliances that people had in 1950, could you get those for 1/10 of the average price that people spend today? In part that’s not possible because the cheapest options in many categories are better than anything you could buy then. But a lot of things are cheaper now, and you would certainly reduce your expenses a lot if you didn’t buy anything that wasn’t commonly used in 1950. Only a few things would take a similar percentage of your income to get a similar product.
Even over the last few years we’ve had very low inflation rates while technology has continued to advance with the release of products that weren’t available at any price a few years ago. In this environment of slowly rising prices there are new technologies on the horizon that promise to make a much bigger difference in our lives than a thinner cell phone so the trend may continue.
Some things are subjected to visible inflation. Commodities that exist in limited quantities such as real estate and food have a clear pattern of rising prices. Fortunately real estate prices, which are a major expense, barely rise faster than inflation in most places over a long enough period. It also has a natural protection since you can buy today and finish paying off your mortgage based on today’s price in 40 years when you’re earning a lot more. Food inflation can be variable over the short term but over a long period I don’t think it’s been too bad since new technology and the sharp drop in the profitability of farms helps make it cheaper and North Americans spend a small percentage of their income on food compared to other countries.
In the end, if you’re concerned about inflation when you’re living off your investment income there are several defenses. One is to simply not inflate your standard of living by buying new things you didn’t have before, which could be enough to completely neutralize current low inflation rates. Another is to own real estate (and not buy more) so you aren’t subjected to rising rents and prices. Finally, you can turn it to your advantage. Two of the major investment choices that help make retirement possible, stocks and rental real estate, protect against inflation since they are part of the inflation calculation.
So far I’m still preparing for a certain rate of inflation. To some degree you can opt out of inflation though. Or if you prepared yourself well enough to be able to spend more every year after you retire, you can inflate the products you buy while still keeping the same margin of safety. As usual, the statistics don’t tell half the story!