I was recently reading an article about the massive effects of investment fees on retirement assets. The gist of the article was that fund managers and investment advisors are thieves because they often take 1-2%, or more, of our invested assets every year in the form of fees. I agree that having a couple of percent of your invested assets taken from you every year hurts. If you look at the prospectus for your mutual funds, you’ll see what fees are taken out, and if you contact your investment advisor, they’ll tell you what their fees are.
These are fees taken in plain sight, so even though it stinks to lose a percentage of invested assets every year, at least you know it, and you can see it happening. I don’t think you can consider someone a thief if you are willingly giving them your money. But investment fees are not the only thing siphoning value out of your assets every year.
THE SILENT THIEF
There is a silent thief out there, consuming your assets, year after year, decade after decade. You can’t avoid this thief by firing your investment advisor, or choosing low cost investments, it is going to be out there sucking the life out of your finances for the rest of your life. This silent thief I’m talking about is inflation.
Whenever anyone starts talking about inflation, eyes start to roll and people start falling asleep. It’s not an inherently thrilling topic, but it’s one that’s important to understand, at least in a general sense. We have to know about the effects of inflation because it’s one of the most important factors in determining our financial strength decades from now.
The reason that inflation is a silent thief is because it’s not at all obvious on a day to day, and year to year basis. Most of us don’t go look up the inflation rate when we are trying to figure out at what our investment returns have really been. The reason that we don’t think about inflation more is because we don’t have any control over it, it is going to happen and there really isn’t anything we can do to stop it. We can try to overcome it with our investment returns, but inflation is still going to take a bite out of our assets every year.
WHAT IS INFLATION?
Inflation is a measure of the rate at which the price of a basket of goods and services increases over time. In other words, it is basically a measure of how the cost of living your life increases from one year to the next. Inflation can be viewed as a progressive decrease in the purchasing power of a nation’s currency over time. It is why your grandparents told you that a cup of coffee used to cost ten cents.
Over the past 100 years the average annual rate of inflation in the U.S. has been around 3%. In some years it has been much higher, and in other years it has been much lower. For the purposes of this article, we’ll assume that inflation is going to be around 3% when averaged over long periods of time.
So what does this mean? It means that every dollar you have, loses about 3% of it’s value every single year. That has a huge impact on how we should approach our investments and what we would consider an acceptable investment return.
SOME INFLATION IS ACTUALLY GOOD
Even though losing a percentage of your money’s value to inflation every year seems pretty terrible, inflation can actually be a good thing for the economy. This is because inflation is a driver of consumer spending.
Since inflation causes the price of goods to increase over time, it motivates consumers to buy things now rather than waiting. If you want a new TV and you know that if you wait until next year, it’s going to be more expensive, it will motivate you to buy the TV now instead of waiting.
The relentless increase in prices due to inflation gives the economy momentum by discouraging consumers from delaying their purchases. More money being spent now rather than later strengthens the overall economy. So there is actually a silver lining to inflation: while it is a big drag on your cash, it can be a boost for the economy.
INFLATION AND INVESTING
One of the primary reasons that we all invest, whether we realize it or not, is to counteract the drag that inflation has on our money. If we’re assuming a long term 3% inflation rate, then you have to be making at least a 3% average return on your investments just so your money is not losing value. If you want to actually grow the purchasing power of your money, the rate of return on your investments needs to exceed the rate of inflation. The following terms are helpful in understanding the effect of inflation on investment returns:
- Nominal return: the revenue from an investment before factoring in external factors, like inflation. An example of a nominal return is the interest rate you see advertised at a bank.
- Real return: the rate of return on an investment after adjusting for external factors like inflation. If you take that advertised interest rate at the bank, and subtract the rate of inflation, you get the real return on your investment. This is the percentage growth in the purchasing power of your money (and that’s what really matters).
Real Return = Nominal Return – Inflation Rate
So if you were to open a savings account that pays 2% interest, you would probably think: “well I’m not making a lot, but at least my money is growing a little bit”. However, the real value of a 2% interest rate is determined by the rate of inflation. If inflation is 3%, and you are making a 2% interest rate on your savings account, your real return is negative 1% (2% – 3% = -1%). The money that sits in you savings account is losing value as time goes by, not gaining value. And the longer your money sits in that account, the less valuable it becomes.
Even though the actual balance in your 2% savings account is going up over time, inflation is causing the real value of your account to decrease faster than your interest accumulates. The numbers in your bank account are going up, but the value of the account in terms of purchasing power is going down.
SAVING AND INFLATION: EXAMPLES
Let’s imagine a man who is 25 years old in 2019. He’s a long term thinker, so he’s already considering what kind of lifestyle he wants to have when he retires in 40 years (in 2069).
He thinks that if he retired today, in 2019, he would need $1 million to have a comfortable retirement lifestyle. But remember, because of inflation, every one of his 2019 dollars is going to be able to buy much, much less in the year 2069. So in order to have what he thinks of as a 2019 $1 million lifestyle, but have it in the year 2069, he’s going to need far more than $1 million. In fact, in 2069, he’s going to need to have over $3.2 million just to get him the lifestyle that $1 million would have gotten him in 2019 (assuming a 3% annual inflation rate)!
If this man decided that he doesn’t trust the stock market, and put all the money he earned during his 40 year career in a savings account that paid practically no interest, how much do you think he’d have to save every year to get that lifestyle he wants when he retires? After factoring in a 3% annual inflation rate, he would need to save about $44,000 per year, every year, for 40 years! Ouch.
Now this guy is smart, so he’s not going to do that. Because he read this article, he knows about the cash-destroying power of inflation. So he invests his money in a diversified index fund, giving him the average return of the stock market, which has been about 10% over the last hundred years. That pesky 3% inflation rate still applies, so his real rate of return is 7%, not 10% (but that’s a lot better than the -3% real return from inflation acting alone). How much would he have to save every year to have that same retirement lifestyle 40 years from now? Only about $4,700 per year if his average annual real return is 7%. Big difference.
MAKE YOUR OWN CALCULATIONS
If you think the stock market is going to return more or less than the 10% we were assuming in this article, or you think inflation is going to be higher or lower than 3% in the future, it’s simple to run your own numbers.
If you want to figure out how much you need to save in order to meet your financial goals many years from now, you have to figure inflation into your calculations somehow. It’s very easy to do. Just find a compound interest calculator on the internet. In the box where you enter your annual interest rate, just subtract your expected inflation rate from your expected interest rate. The result of the calculation will be your future nest-egg in today’s dollars.
ARE YOU GOING TO GET ROBBED BY INFLATION?
Now, when you run through some of these calculations, the results can seem bleak. But don’t be too discouraged, because some compensation for inflation is baked into our lives.
One way in which inflation is accounted for is the increase in your wages over time. When you are near the end of your career, you are pretty much always making a lot more money than you did when you got your first job. Your increases in salary over time play a big role in correcting for the effects of inflation on your investing.
If you save a fixed percentage of your annual salary every year, you will automatically be canceling out much of the effect that inflation has on your money. As your income increases over time, so will your annual savings.
If your retirement savings goal is just to max out your 401(k) every year, then inflation is still being accounted for. The 401(k) contribution limit is periodically increased, and these increases allow you to keep up with inflation. For example, do you know what the 401(k) contribution limit was in 1990? Only $7,979. In 2019, the limit is $19,000. This amounts to an average annual increase of about 3% per year over that time period. Remember that the average long term inflation rate has been about 3% annually, so the periodic increases in 401(k) contributions have helped to account for the long term effects of inflation.
As time goes by and you make more, hopefully you will also save proportionally more, canceling out much of the wealth-destroying effect of inflation.
And if you have a well designed, low-cost investment portfolio, your investment returns should exceed the rate of inflation over time…and then some. Investment returns are the most important factor in overcoming inflation.
Hopefully, this article has helped you grasp what inflation is, why it is worth thinking about, and why it’s so important to invest wisely. With smart investing and an understanding of the forces devaluing your assets, you can beat inflation and take your money back from that silent thief.