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Inflation seems to be rearing its ugly and insidious head. And that can mean only one thing for those saving for or living in retirement: Without a plan of action to mitigate the effects of rising prices, you're certain to lose purchasing power over the course of time.
Consider the results of recent survey conducted by the Senior Citizens League. Since 2000, seniors have lost almost one-third of their buying power, according to the SCL's annual survey of senior costs. "To put it in perspective, for every $100 worth of expenses seniors could afford in 2000, they can afford just $69 today," Ed Cates, chairman of the SCL said in a release.
Specifically, the SCL found in its study that 27 of 33 typical costs seniors must bear in retirement (housing, transportation, medical, food, recreation, communication, and apparel) exceeded the amount of increase in the Social Security cost-of-living adjustment (COLA) between 2000 and January 2014.
For instance, COLAs have been growing at record lows levels recently, averaging just 2.47% a year since January 2000. That's well below the pace of inflation for certain expenditures.
The price of a gallon of gasoline has risen 160%, from $1.31 in 2000 to $3.41 in 2014; a gallon of heating oil has risen 251% from $1.15 in 2000 to $4.02 in 2014; homeowner's insurance has risen 123% from $508 a year to $1,135; real estate taxes have risen 104% from $696 in 2000 to $1,405 in 2014; and the monthly Medicare Part B premium has risen 131% from $45.50 to $104.90 in 2014. And, the only items that fell in price were prescription drugs and apparel.
Given the rise in prices over the long term and its often unseen effect on your ability to maintain your standard of living in retirement — especially if the bulk of your income comes from Social Security — what can you do to protect yourself against the ravages of inflation?
Well, in an ideal world, you'd be able to "specifically hedge 'retiree inflation,'" said Michael Ashton, a chartered financial analyst and managing principal of Enduring Investments. In an ideal world, you'd be able to buy a customized inflation basket, or an annuity linked to your personal inflation. Unfortunately, the market has been very slow to develop new products such as that.
Meanwhile, you'll have to settle for hedging only headline inflation instead of golden-years inflation, said Ashton, whose firm has developed strategies to replicate some subcomponents retiree inflation.
You'll also have to settle for what Ashton said are the same answers to the age-old question: What can you do when inflation eats away at your savings faster than you had planned/hedged for?
The first option: You have to save more, or keep working, or diminish your lifestyle, which Ashton said, is obviously an answer no one wants to hear, but it is the low-risk strategy.
The second possibility is to take more risk with part of your portfolio, which Ashton said is a strategy he dislikes. Why so? "It doubles up your risk if inflation accelerates since both stocks and bonds do poorly in inflationary environments," he said. "But if you go this route, you ought to at least take great care about how you take that extra risk."
Others also say that investing in assets that keep pace or outpace inflation is a time-honored though perhaps not fail-safe way of making sure you don't lose your purchasing power.
"The finding that COLA adjustments to Social Security are not keeping up with a range of costs faced by retirees suggests that people saving and investing for retirement need to focus on having adequate exposure to asset classes that tend to keep pace with inflation," said Geoff Considine, the president and founder of Quantext.
Considine said Treasury Inflation Protected Securities, or TIPS, are designed to allow investors to maintain their purchasing power in terms of the consumer-price index (CPI). "But CPI may not be sufficient as a measure of inflation, depending upon exactly what people spend their money on," he said.
Good investments are those such as energy equities and real estate (REITs) that see their value increase with inflation, Considine said. "Energy prices tend to rise as part of overall inflation, and higher energy prices make energy producers more attractive," he said. "REITs can also be attractive as a way to generate rising income in an inflationary environment."
He also noted that broad commodity funds such as the PowerShares DB Commodity Index Tracking Fund (DBC) provide direct exposure to a range of commodities and provide an inflation hedge, too, but they can be volatile.
Meanwhile, other advisers take a slightly different approach to hedging inflation.
"I am in the minority of advisers who have been speaking on this issue for years," said James Shambo, a certified public account and personal financial specialist with Lifetime Planning Concepts.
Shambo, by way of background, wrote a paper back in 2008, "The Hedonic Pleasure Index — A New Model for Spending Inflation," that identified that CPI is merely a price index and is a poor measurement for spending inflation.
"The impact I identified affects younger workers more, but even many [retirees] more each year than CPI measures," he noted. In addition, he said CPI-E, which measures the baskets of goods that the elderly are more likely to consume, is a price index only, too.
Shambo said the first step to understanding spending inflation is for those planning for retirement to model spending using a higher rate of inflation than what CPI suggests as an alternative to using CPI alone. "It will suggest the need for a higher portfolio going into retirement and that will be the best advice anyone can give most pre-retirees," Shambo said. "Yes, they may have to work longer to achieve that but uncertainty is all that awaits a retiree, so be prepared."
The reality, Shambo said, is that people spend on price changes, quantity changes, and quality changes. "My advice differs depending on the (person) and their spending profile."
Yes, it might sound wishy-washy, but it's true, he said. "All clients are snowflakes and need individualized planning for their unique needs," said Shambo, who recommends mitigating inflation by answering the following questions:
"If the answer is they are a spendthrift with low investments relative to spending, no discretionary spending as a cushion, no collars of future unknown risks then they should not retire until they have worked on those issues," Shambo said.
"If they are already retired and are falling behind today, then they should reassess their budget and look for ways to cut costs today rather than waiting and hoping things will change," he said. "They will not. Social Security is not going to improve especially for the wealthy, Medicare premiums are not going to go down, health-care costs are rising across the globe and people want an improving standard of living — not a declining one — as they retire."
And, yes, Shambo said, the possibility the government will change how it adjusts Social Security's COLA — from its current method to the more slowly growing chained CPI — is a real possibility not just for Social Security but also for tax brackets, Medicare spending and anything else affected by government spending. (Current estimates of that change would reduce the COLA by 0.3% to 0.4% a year and ironically may be the best of the proposed solutions to Social Security, Shambo said.)
Shambo's bottom line: Make forecasts of future needs by assuming alternative spending inflation rates rather than using CPI alone. And, run scenarios of a spending inflation between 0.2% and 1.5% more than CPI depending on how your spending behavior fits into the CPI model.
"Many people, for example, do not substitute hamburger for steak as the Bureau of Labor Statistics (BLS) assumes," he said. "Consumers cannot ask the car dealer to remove the quality improvements from their car purchases, so the air bag that is not in CPI because it is a quality improvement still needs to be paid for when you buy a car and other behaviors the BLS assumes may fit one (person) and not the other."
His other bit of advice for those who want to tame the ill effects of inflation during their golden years: "Envisioning your retirement early and often may help you plan for a spending burst in the early phase of retirement as the new hobbies, toys, travel and a second home in the Sunbelt are considered," he said. "What does retirement look like through your eyes? Those are the only eyes that matter, so start envisioning now."
Sadly, Shambo said, the vast majority of America has saved too little to fit in his model. "They will spend closer to CPI as they have no choice and their standard of living will decline in retirement," he said. "But if they start planning now, perhaps they will have a choice when they retire and only then will the problem (of Social Security's COLA not keeping pace with inflation) be an issue for them, and that would be a good problem to have."