13 Mar Inflation – Who Cares?
During the Last Decade, maybe longer, in my career as an advisor my discussions with clients and prospects regarding the threat of inflation have proved largely theoretical. I sometimes feel like an air steward at the beginning of every meeting providing a safety demonstration that in the unlikely event of inflation, higher interest rates etc…meanwhile my passengers are reading the paper or staring out of the window. So why do I persist in this ritual and what does the threat of inflation look like in the reality.
Inflation is not all bad. In a growing economy modest inflation (1-3%) is a gentle tailwind for the working population. For those in the asset accumulation or wealth building phase of their lives inflation usually accompanies a constructive economic environment where wages and asset prices are growing and fixed debts such as mortgages are being eroded in real terms. When inflation is benign interest rates can be controlled. Of course, this theory is disrupted when economies overheat and inflation accelerates. Interest rates are then forced higher, wages fall behind prices and debt becomes more expensive. But even in this situation the working asset accumulation population generally has the time to pull themselves through.
Inflation of all forms is most damaging during the asset distribution phase of life, those who live off their accumulated wealth e.g. retirees. Yes, modest inflation can help those assets continue to build but increased prices becomes a dangerous long-term termite. This issue is compounded by increased life expectancy where your assets must last you longer. My job as an investment advisor is to determine A. How much you will need to live on when/if you choose to retire and B. How to get there.
What does inflation look like in simple numbers? Well the chart below provides the average life expectancy of retirees;
I would argue that long-term return expectations have not changed in the past 70 years but the number of years you need to provide for has increased by more than 5 years or almost 40%. I expect this number will continue to grow. This is also compounded by the increase in medical costs that will likely be required over that period.
What does inflation do to these numbers? If inflation was to grow on average 3.5% per annum over twenty years retirement purchasing power during this period would decline 50%. In other words, the cost of living would double. Reasonable inflation expectations must be built into your long-term projections if you are to avoid running out of money during your lifetime. If your target is to build assets to fund retirement of $3,000,000 (a reasonable number) and you have not factored in realistic inflation assumptions then you need to up that number maybe by as much as 50%. That’s a big change but one you must be prepared for.
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