Lesson 4: Inflation Rates and Retirement

Growing up in Latin America during the 1980s, I quickly learned how to adapt to the impact of inflation in daily life. With annual inflation rates reaching over triple digits, even young children knew never to expect the same price twice, cash wasn’t allowed to sit idle and interest rates on bank deposits were designed to outpace inflation. We knew that salaries were linked to the U.S. dollar and pension income was stated in unidades reales, which is effectively a basket of consumable goods. Yes, complicated, but a fact of life.

Then, as I moved back to a monetarily stable North American environment, the debilitating power of inflation moved to my mental back burner. It toppled down my list of risk and worries. After all, the consumer price index (CPI) in the U.S. has increased by a compound rate of only 2.96 percent per annum over the last 25 years. In kindergarten, that was a decent weekly rate. Indeed, it is easy to get lulled into a false sense of security that inflation is just not an issue anymore. The Federal Reserve’s main policy mandate is to keep prices stable and even a whiff of unexpected pressure sends them into a tightening tizzy.

But, as I started researching the area of retirement income planning, I found that the relatively low inflation rates we have experienced in the last quarter century might actually be just as dangerous as the hyper-inflation rates I grew up with. This is because low numbers can be easily ignored. Yet, over long horizons they can be just as deadly, especially if you are not compensated for this risk and don’t know your own inflation rate. Stay with me here. One of the main financial risks we face in retirement is the topic of this month’s lesson: your unknown and age-specific personal inflation rate.

First, Table 1 illustrates the impact of relatively benign inflation rates over long periods of time. Here is how to read this table. Imagine you are getting a $1,000 pension income check every single month of your retirement years, but that this check is not adjusted for inflation. What this means is that your nominal income stays at $1,000, but its real purchasing power declines steadily with time. As you age, the same check buys you less. The table tells exactly how much $1,000 will buy you in today’s dollars, depending on the unknown value of inflation going forward.

Notice that a 2 percent increase in the inflation rate, from 2 percent to 4 percent per year, can erode the purchasing power of $1,000 by almost 40 percent, from $610 to $375, at the 25-year horizon. I pick 25 years since it is the median remaining lifespan for a newly retired couple, while 2 percent to 4 percent inflation is arguably a reasonable aggregate range.

But actually, the inflation story gets even more interesting. It seems the U.S. Department of Labor, via its Bureau of Labor Statistics (BLS), has created an entirely new inflation index for the elderly. They called it the CPI-E and it is meant to capture the inflation rate that is unique for Americans age 62 and older.

Why would inflation be different for the elderly? In fact, how does inflation get measured, at all? The answer to these questions comes down to our spending habits. Boiled down to its essence, statisticians measure inflation partially based on how we spend our money.

Basically, they measure price changes for hundreds of categories and items each month. Some of these items increase in price while others decline or stay the same. The weights placed on the different items and components reflect our average spending habits. If the typical American spends three times more money on banana products than avocado products, then the index weight placed on bananas is three times as high as the index weight placed on avocados. This is regardless of whether you personally are allergic to bananas and love avocados.

Moving on, the consumer price index for wage earners and clerical workers is labeled and abbreviated CPI-W. The precise way this index is created is by reflecting the spending habits of this group, which is about 32 percent of the U.S. population. Working Americans spend about four times as much on food and beverages as on apparel, and they spend eight times more on housing than they do on recreation, for instance. The components in Table 2 provide the weights on the various categories that make up the CPI-W, and obviously they must add up to one. Note that the higher the group weighting or relative importance, the more a price change for the group will impact the overall inflation rate.

But, the elderly spend their money differently!

As you can see from the third and fourth columns in Table 2, the relative importance placed on the various sub-components differs for the regular (CPI-W) versus the elderly (CPI-E) version. For example, in the CPI-E medical care has twice the weight as it has in the CPI-W. The reason for this is because the elderly spend a greater fraction of their income on medical care. At the opposite end is the weighting that is placed on food and beverages. Its relative importance in the elderly inflation rate is 0.1275 compared to 0.1648 within the regular rate. Remember that each sub-category has its own inflation rate.

Here is the bottom line. From early 1982 until late December 2006, the compound annual inflation rate in the U.S. as measured by the regular inflation rate for wage earners was 2.96 percent per annum. During the exact same period the inflation rate for the elderly was 3.30 percent, which is an average of almost 35 basis points more each and every year during the last 25 years. Moreover, every single year the CPI-E increases by more than the CPI-W, in some cases by a full percentage point.