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Posted: May 01, 2012

Retirement income inflation

Retirees are getting hammered by it

Charles Farrell

Many of us think of inflation simply as an increase in prices of consumer goods, such as gas and food. But there's another type of inflation that impacts the price of assets, and it's hitting retirees particularly hard. Retired investors are getting hammered by this type of inflation because it's costing them three times as much money to buy a retirement income stream. 

Here's an example. Let's assume you were retired in the year 2000 and you invested $1 million in U.S. Treasury bonds that matured in the year 2012.  You would have received about $60,000 a year in annual interest payments on that $1 million.  Over the last 12 years, you went merrily along scooping up that nice income stream while the financial markets were in chaos. You spent lavishly on trips to Costco and fishing expeditions with the grandkids.

Now those bonds have matured and you've got your $1 million back.  You go to invest in another portfolio of Treasury bonds and find out that instead of earning $60,000 a year, you can now only earn a miserly $20,000.  Thus, you had a pool of money (the $1 million) that created $60,000 a year of income that now only creates $20,000 a year of income. 

Your income stream has declined by about 65%, and that means your purchasing power has declined by 65%, so in effect, you are being crushed by an insidious type of inflation.  But it gets worse.  Everything that you could have bought in the year 2000 for $60,000, now costs over $80,000 as a result of inflation. But you can only generate about $20,000 of income on that same pool of capital, and thus the purchasing power of your $1 million is actually about 75% less. 

Another way to think about it is that you now need $3 million of assets to buy the income stream you could have bought 12 years ago with $1 million of assets.

For retired investors, collapsing interest rates are in many ways more damaging than a situation where inflation picks up but your fixed income returns are adjusted to outpace inflation.  For example, if inflation ran at 5% and Treasury yields were 7% (historically intermediate term Treasury yields have had about a 2% spread above inflation), retired investors would be better off.  Even if the goods and services you could have bought in 2000 for $60,000 now cost $80,000, at least you would be generating $70,000 a year in interest.

So what should retired investors do?

They will likely need to take more risk to generate more income, as most investors can't live off a 2% return from bonds.  A prudent approach to generating more income is to focus on investing in a diverse group of companies that are paying meaningful dividends, and are growing those dividends at a rate comparable to the company's earnings.  While this type of income is not guaranteed, the dividend yield from many financially strong companies exceeds the interest payments investors can receive from bonds, and the dividends may well grow, thus producing even more income.  Otherwise, investors face the likely depletion of savings as retirement distribution rates outpace the interest payments they can receive from bonds.

If you have any questions about how inflation is impacting retirees, please don't hesitate to call me. To learn more about dividend investing for retirement income, visit our Farrell Northstar Retirement Income Index site at www.northstarinvest.com/fnri 

 

Charles Farrell is the author of the book Your Money Ratios: 8 Simple Tools for Financial Security, published in December 2009 and called "one of the best financial books to cross our desks this year" by the Wall Street Journal. The book was released in paperback in January 2011. Farrell is a principal with Denver-based Northstar Investment Advisors, LLC, an independent, registered investment advisor. His services include portfolio investment management, retirement income management, wealth transfer and portfolio tax planning. Prior to working as an investment advisor, Mr. Farrell was a tax attorney representing privately held businesses on tax, retirement and estate planning matters.

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