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When we discuss inflation and retirement planning with clients, the discussion typically revolves around the detrimental effects of inflation on future expenses. Inflation has been one of the “facts of life” that we all have faced, and usually assume to be a bad thing.
When I teach classes on retirement, I usually tell a story about my high school days (several decades ago). It was not unusual for me to stop on my way to school and buy an RC Cola n a 16 oz. bottle. The drink cost .50, and had a two cent sales tax, for a grand total of 52 cents. The nearest current equivalent to that scenario now involves a purchase of a 20 oz. drink, with an average cost of $1.89 at a local convenience store. So, we now typically pay a little over 300% more for the same type of good.
Now, imagine what inflation will do to higher-level living expenses such as health care, automobile expenses, and utilities. Folks are living longer in retirement, and retirement years can stretch in excess of 30 years. So, prudent financial planning includes attempts to factor in the effects of inflation on these costs.
So, the way to address the potential (more appropriately state, expected) increase in these costs necessitates creating cash flows that can increase to counteract these effects.
If inflation continues at an average annual rate of 3.5%, it becomes necessary to generate returns that generate at least 3.5% growth, plus factor in the concurrent effects of taxes on these returns, which typically will push the need for returns that head north of 5%.
Current short term rates on savings vehicles, such as CD’s and Cash Accounts, are not generating this level of returns. So, how do we address the potential lack of purchasing power?
One way to address this “lack of growth”, is by utilizing assets in financial plans that are directly correlated with inflation. This means that we are actually seeking inflation-affected assets to add to our financial equations.
It may seem a little counter-intuitive, but in order to do this, we need to try to minimize risk to cash flows, by increasing short term risk in financial assets. In order to do this, adding assets such as stocks and alternative investments are ways to attempt to use inflation to our advantage.
It is not stated often, but stock ownership (a form of business ownership) can be utilized as a hedge to inflation, as stocks are denominated in dollars. When inflation begins to push dollar-related assets up in cost, this can potentially also happen with stocks in portfolios.
Couple this effect with the average return of the S&P 500 approximately exceeding 10% over the last 80 years, stocks should be considered as a major factor of financial planning, going forward.
So, the next time that your financial advisor says, “let’s purchase stocks in your portfolio to lessen risk over time”, do not look at him or her as if he or she just told you that aliens are landing in your back yard.
Stocks can actually provide some hedge against inflation, because a company’s revenues and profits should grow at the same rate as inflation, after a period of adjustment. Of course, it should be noted that periods of high inflation can impact stock performance negatively, which will vary greatly depending on the type of stock, and other factors. Stock investing involves risk, including loss of principal.
At Deacon Wealth Management, we can help you analyze your current financial situation and help you as you attempt to fulfill your financial goals. Feel free to call on us at 540-371-8585, or on the web at www.deaconwealth.com.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
Alternative investments may not be suitable for all investors, and involved special risks such as leveraging the investment, potential adverse market forces, regulatory changes and potentially illiquidity. The strategies employed in the management of alternative investments may accelerate the velocity of potential losses. CDs are FDIC insured to specific limits and offer a fixed rate of return if held to maturity.