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Quadrant II: Keeping Up With Inflation

You might have heard the line about how inflation means sitting on your nest egg – but not giving you anything to crow about.

No doubt about it, inflation is an investor's silent enemy. Its steady, subtle erosion of purchasing power is rarely noticed early. Every year, the money you make will buy a little less per dollar than it did a year ago. Over the years, though, as expenses grow and incomes don't, most people can't help but recognize its cumulative damage.

What is inflation? Simply stated, inflation is an increase in the general cost of goods and services. Inflation can erode your purchasing power and your standard of living during retirement. To maintain your living standards, your income and retirement plan needs to keep pace with the change in costs. This increase should come from a pool of assets that is also growing or from a pool that is large enough to support your needs without being depleted too soon.

Inflation can cause considerable harm. Over the last decade, for example, the annual increase in the Consumer Price Index (CPI)—a common measure of inflation—has averaged about 2.44%. Even at this low rate, a car purchased for $20,000 today will cost almost $33,000 in 20 years.

So how does inflation wreak havoc on our savings?

Let’s look at some numbers to see just how inflation works. A product or a service costing $100 at age 65 will cost $208 at age 80 assuming an inflation rate of 5 percent between the age of 65 and 80.

Somehow, you’re going to have to grow your savings to have enough money to pay for inflation. That is, to keep your money ahead of inflation.

What’s the best way to do just that? For starters, estimate the projected inflation rate that you’ll be aiming for. For instance, selecting an inflation rate of 5 percent or more would be a conservative approach ensuring that any projections you make will not fall short of your retirement goals on account of inflation. An inflation rate of 3 or 4 percent is probably a closer estimate of the average yearly inflation rate. With a lower estimated inflation rate, 2 percent or less, you are running a high risk of falling considerably short of what you will need for retirement income.

Also remember that, whether you are putting together a savings plan by yourself or with professional help, you should choose the inflation factor that fits the level of risk you are ready to assume in a worst-case scenario.

To clear things up a bit more, take a look at the table below that was developed by the folks at the financial services firm CCH International. Simply take the amount of money at issue and multiply it by an inflation factor from the table. That will give you the amount of cash that you will need in the future to beat back inflation. To have the same buying power as $1,000 today, for example, you will need $1,280 five years from now assuming a 5 percent inflation rate ($1,000 x 1.28).


Inflation Factors for Selected Annual Inflation Rate Over a Number of Years
Years 3% Inflation Rate 4% Inflation Rate 5% Inflation Rate

5 1.16 1.22 1.28
10 1.34 1.48 1.63
15 1.56 1.80 2.08
20 1.81 2.19 2.65
25 2.09 2.67 3.39
30 2.43 3.24 4.32
35 2.81 3.95 5.52
40 3.26 4.80 7.04

Source: CCH Incorporated


The main thing to remember with inflation is that while the amount of money you have saved for retirement may look fine today, trust me, it won’t be enough. If you’ve saved $100,000 for retirement, for example, you’re going to actually need about twice that to pay for the goods and services that you enjoy today.

Published Nov 22 2006, 07:33 PM by moneycoach
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