Wednesday, July 9, 2008

Your shrinking dollar
David D. Witt, Ph.D.

If you stuffed $1,000 into your bedroom mattress tonight and didn’t pull it out for 20 years, how much do you think that $1,000 would be worth? That $1,000 would have shrunk to today’s equivalent of $456. This shows why you must plan your retirement strategy to compensate and overcome the effects of inflation.

Don’t ignore inflation

Good financial planning must always take inflation into account. If you disregard inflation, you’ll probably be more conservative in your investing and put more of your money in fixed-income investments because the return is guaranteed. A 5% return may be just fine for you and you have also avoided market risk (the risk that the price decreases). If you take inflation into account, however, and there is 4% inflation, your actual return is only 1%. Due to inflation, each dollar's purchasing power will be less each year. That nice retirement nest egg you have calculated may look fine in today's dollars but will have much less purchasing power when the time comes to draw on it. So if you’ve calculated that you’ll have $25,000 for your yearlyretirement income, that figure may look fine if that’s what you’re living on right now. The fact is, however, you may look fine but you’re going to be in deep trouble. You may actually need $50,000 to maintain today's standard of living in the year you retire, and that amount will increase every year.

Reduce your standard of living

You may be assuming that your standard of living will increase over time until you retire. With inflation eroding the purchasing power of each dollar, think again about increasing your standard of living. You will have a much better chance of achieving your retirement goal if you maintain (or even reduce) today's standard of living and save as much as you can.

If you’re still young enough that your retirement strategy can involve long-term investing (10 years or more), most of your money should be in the stock market. Unless you really know your stocks, your best bet probably will be in mutual funds in traditionally higher yielding funds, such as growth, income or index funds.

Fixed-income investments won’t beat inflation
Fixed-income investments like certificates of deposit or money-market accounts will barely beat inflation over time. Because you’re investing for the long term, don’t worry about market risk, because it doesn't matter if your portfolio’s value rises and falls at times. The price of your stock or mutual fund only matters when you sell that particular investment.

Keep in mind that once you reach retirement, inflation will continue and you’re likely to live 20 years or more beyond retirement age. Any fixed monthly income benefit you’ve set yourself up to receive will decrease in real dollars with each year because of inflation, so you’ll need to rely on other investments as time goes forward.

Set your retirement plan based on the assumption that you’ll live to at least age 85 and that your expenses will rise each year. If you’re married, you should plan your strategy based on the assumption that one of you will live to age 90.

The worst situation to be in is to have outlived your money, and inflation is the surest reason why this may happen. The problem with inflation is that it creates illusions -- the dollar bill that you’re holding in your hand today will be worth less tomorrow.

Good retirement planning must include inflation, both before and after retirement. The worst that can happen is that you overestimate inflation and end up with more money than you need. Your heirs will thank you.

The majority of the population will have to spend most of their retirement life working again in order to keep up with the escalating medical cost and living standard. People who fall into this category will have to learn to "enjoy" working hard for the rest of their life.

Talk to the right person, there is still time to change the course of the outcome!

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