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Inflation & Retirement Planning

Fighting inflation in retirement planning

Inflation asset protection is discussed in the following article. It goes on to explain when inflation is irrelevant and when it could affect an investing pre-retiree. When retirement planning, many individuals will choose a conservative stance in regards to their investments and this will drive the funds available to them during retirement.

Retirement Planning: Is Inflation Relevant?

Inflation becomes irrelevant once an individual has decided on their tolerance of risk. If the individual were to choose to invest in bonds, mutual funds and stocks, inflation generally is not a cause for concern – let us explain why.

Definition of Inflation

Inflation will occur when there is an increase in the cost of goods or services due to the creation of money by the Federal Reserve. Inflation is often measured by the Consumer Price Index (CPI). In 1998, milk cost about $1 per gallon. Inflation is evident since we are now paying more than $3 a gallon. There are many financial planners who will take the time to ask some important questions of clients. Let's suppose that we are dealing with a 63 year old 7 years before retirement and they answer the questions as follows::
  • When do you want to retire and what is the number of remaining years until you retire or desire to retire? 7 years – the number of remaining years until retirement
  • Based on the current dollar value, how much money is required after taxes to sustain yourself or to live the lifestyle you desire when you do retire? I am not sure, but I would say $4K per month ($48K per year) – the money that is required before taxes to live the lifestyle desired at retirement – who knows what the income tax will be in 5-10 years.
  • At what age do you think you will live to? I would guess 93 – expected to live to age 93.
  • What do you anticipate to be an average rate of return over the coming 30 years? 7% – the expected rate of return for the investments
  • How much do you currently have to invest in (stocks, bonds, mutual funds, etc) for retirement? $390,000 (in a 401(k) plan) – the amount of current money that is available for investment purposes
  • What is your level of risk tolerance for investing? Conservative – the level of risk tolerance for investing
When forecasting, financial planners typically will use various rates of return: aggressive 8-9%, moderate 6-7% and conservative 3-4%. Typical fees for 401(k) plans that are managed by a financial planner should be between 1 to 2.5% annually.

How would a financial planner assist a clientsomeone in reaching their retirement goal if the goal isthey need $3036,000 pre-tax annually when only using money from a 401(k) account?

In order to withdraw this amount from the 401(k) account and avoid running out of money later in life, the current balance of the account, which is $390,000, must grow annually by 7% for 30 years. This means that there would be a net rate of return of 5.5% after annual expenses if we suppose the annual administrative fee is 1.5% per year. How is it possible for any financial planner to guarantee these returns? While it is technically possible with a properly balances mix of stocks, bonds and money market accounts, it is not likely - when was the last time you had of more than 7% rate of return on your portfolio for 3 or 4 years in a row, never mind 25 to 30 years? In the stock market, there are no guarantees of returns.
If we take into account this client's conservative level of risk tolerance for investing we know that he will have no desire to be involved with mutual funds or stocks. Instead, this client will invest in Cash Deposits (CDs)/money markets or even bonds which are conservative investment strategies. Some financial planners will try to persuade the client to make investments in mutual funds and stocks, but again, there is no guarantee that these will return 7% over the period of the next 25-30 years. The chance of a 7% return over 30 years in CD and bonds is nil.

How Inflation Affects the Yearly Withdrawn Amount

For the past 30 years, inflation has been around 3% every year. Looking at these numbers, in five years, a client would have to take out $55,000 from their 401(k) account when they are 70 to account for inflation. By the time the client was 85, they would have to take out $79,260 a year and $106,600 at the age of 90.

Three Ways to Protect from Inflation:

There are generally three ways for a client to retire with the desirable lifestyle (or, numerically speaking, be able to withdraw $48k in current dollar value when he/she is age 70). These include:
  1. Increase the rate of return on his/her investment portfolio over and above what the conservative investments can return
  2. Increase the amount save before he/she retires
  3. He will need to reduce expenses during retirement
Let's suppose that the client has no way to increase his/her savings in the five years preceding retirement. In this case, how could a financial planner increase the wealth of the client so they can have $48,000 a year in retirement (pre-tax)? How is it possible to assist the client to combat inflation?
In reality, there is nothing the advisor or planner can do because of the conservative risk tolerance of the individual. In order to generate the rates of return that are needed, the client would have to buy stocks and bonds, which is something they do not wish to do because of his risk tolerance.

Discussing Inflation

Once a client has made up in his mind on their level of risk tolerance, there are only two rationalizations to talk about inflation asset protection. These include:
  • If he can allocate more money for investments and/or save more money
  • Whether he should manage to reduce expenses during retirement
In short, inflation is only relevant when it is being used as a motivational tool that will urge clients to save more money or spend less when they enter retirement.

How Financial Planners Deal with Inflation

Many financial planners will use inflation as an excuse to persuade clients to change their investment philosophy. Financial planners want the client to forget the conservative philosophy and adopt an aggressive one so they can achieve their goals. Many financial planners will not even suggest the use of Fixed Indexed Annuities because they claim that the caps will place a limit on the ability to keep up with inflation. Financial planners who believe this are wrong and they should disclose this option to clients.
Contact Estate Street Partners to discuss how we can help protect your assets for retirement and how to transfer your assets to your beneficiaries.
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