Can We Be Optimistic? Part 1

In spite of what we see on the news every day there are reasons to be optimistic about the future. People are living longer and healthier lives. And enjoying themselves long after they retire. But to realize the promise of the future one must also consider its challenges. What are the challenges that your clients must be prepared to face in the future?

There are the challenges of inflation as well as volatile investments and savings accounts. As we have seen in recent years, interest rates can go up and down and the stock market can go up and down in an unpredictable fashion.

There is the challenge of taxation as well. Not just income taxes, but capital gains tax, tax on Social Security income and estate taxes as well.

These are some of the challenges that your clients have probably thought about from time to time. But there is one additional challenge that many people don’t really pay much attention to and that is the potential that if we live long enough we might outlive our income.

In this blog we are going to look at these challenges. (Next week, we’ll look at solutions.)

First, let’s look at inflation. The price for many of the things we all used in 1963 and what they increased to by the year 2000 gives us some guidance as to what the future may hold:

• Tennis shoes: 1963 $4.95; 2000 $55.75
• Postage stamp: 1963 – 5 cents; 2000 34 cents
• Movie theater ticket: 1963 $1; 2000 $8.50

The concern that all our clients share is, will their income keep pace with cost of living increases in the future?

If it doesn’t, then will they be forced to deal with some very major problems. For example, at 4 percent inflation, the purchasing power of $100,000 erodes to just $30,000 over a period of 35 years. That would mean that their savings would only buy about one third of what it would today.

Calculating the impact of future inflation is pretty easy if we follow a formula referred to as the rule of 72. To find how long it will take the prices of goods and services to double all we do is divide the number 72 by the current inflation rate. For example, if the inflation rate is 4 percent then 72 divided by 4 percent equals 18. That means that in 18 years prices will double. Or another way of looking at it is that in 18 years our savings account is worth half (in terms of purchasing power) of what it is worth today.

If the inflation rate averaged 2 percent then it would take 36 years for prices to double. At a 10 percent inflation rate prices double in only a little more than seven years.

No one knows what future rates of inflation will be, but at almost any level inflation means a potential problem.

People concerned with inflation often turn to the equity markets. They view the historical steady climb of equities as a way to help combat the effects of inflation. However, while past performance of the stock market in general might be impressive, there are no guarantees regarding future performance. Even powerful long-term upward trends are usually made up of a series of shorter-term ups and downs. The volatility of equities has caused even the most experienced investors to suffer through many sleepless nights.

The down periods can present special problems for retirees who have an immediate need to access savings to pay for unexpected medical expenses or for other unforeseen emergencies.

Many retirees who are risk averse to market volatility place a large portion of their savings in bank CDs. This can allow them to avoid the ups and downs of equities and allow them to sleep more peacefully.

While CDs protect their savings from market risk, the interest rates they earn can fluctuate dramatically over time. Volatility of interest rates can cause as many sleepless nights as the ups and downs of equities, especially for those living on a fixed retirement income. During periods when interest rates are low, your client may face a loss of purchasing power with CDs after taxes and inflation.

Consider the impact of inflation and taxes on interest earnings. Earnings from CDs are currently taxable in the year earned, whether they are withdrawn or left to accumulate.

After deducting your client’s income taxes, you can see that net earnings are actually much lower.

Interest earnings          7%                    6%                    5%                    4%

Federal & State           -2.45%             -2.10%             -1.75%             -1.05%

Income taxes @ 35%