For the past couple of years, a key metric that has impacted most households in a sudden, meaningful way has been inflation. We have seen the price of goods increase in every aspect of our lives, which has put considerable pressure on households, particularly those of lower income where wages may have already been pretty close to the level of expenses. It may make you wonder why we generally haven’t been talking about the threat of inflation prior to this current episode of price increases.
That answer is relatively simple – it is because it has not affected the majority of people for quite some time. While the cost of health care averaged well above 4% annual growth for the last several decades, overall inflation really has not been a major concern. Prior to 2021, you would have to go all the way back to 1995 to even find an annual inflation rate with a 3 in front of it. Unless you carried significant personal health care expenditures, you might not have had much inflation to worry about at all – and if you are older, Medicare likely ended up picking up a significant portion of the expense, leaving it to the general taxpayer to foot the bill.
Inflation has also historically been significantly worse than as of late. If you go back to the 1970’s and 1980’s, according to the Bureau of Labor Statistics (2023) the geometric mean inflation for those two decades was 5.8% annually (Geometric mean uses prior years to compound the average, versus an arithmetic average which just adds each annual rate together; the arithmetic mean is less accurate but is used by lazy news media because it tends to produce a scarier number). By comparison, in 2022 the annual inflation rate was 6.2%, but the five-year geometric mean inflation is 2.8% and the ten-year geometric mean is 2.3% (Bureau of Labor Statistics, 2023). This is likely why the Federal Reserve is using its hammer of raising interest rates as aggressively as it has; they understand the danger of inflation becoming a persistent force, which in turn increases wealth inequality and decreases quality of life for Americans. That said, if you are curious how the stock market performed over those two hyperinflation decades, the annual return was 10.7% a year, or 4.9% annually above the inflation rate. This demonstrates that even in a higher inflation environment, long term investors in businesses on average have considerably outpaced the scourge of inflation.
The Effect of Inflation on the Answer to The Big Question
I am often asked by both clients and non-clients alike “How much money do I need in order to retire?” This is a difficult question to answer. One key reason why this question is difficult is that most people do not know years or decades in advance how they want to live when they retire. This makes it challenging to establish how much their lifestyle will cost, and therefore how much they will need to earn, either through Social Security, pension, income, or investment savings, to reach the goal. It is obvious that a more expensive lifestyle or set of needs during retirement will require more assets to support them. To at least begin to fill this blank, most people assume they want to live with a similar financial footprint to how they live right now. When one does not know the answer, this is a reasonable starting point.
Next, we need to forecast what that dollar amount in today’s dollars means in the future. This involves taking however much you are spending today and multiplying it by an assumed interest rate for the period.
The chart above shows the effect of inflation on a base lifestyle of $100,000, $150,000, and $200,000 in today’s dollars over a ten-year period. At a 2% rate of inflation, which is the Federal Reserve’s stated inflation goal, a lifestyle costing $100,000 a year today would cost $121,899 in ten years’ time. Even adding just a quarter of a percentage point to the rate, that amount goes up to $124,920, a difference of 2.5%. This might not seem like a problem.
The chart above shows the effect of inflation on a base lifestyle of $100,000, $150,000, and $200,000 in today’s dollars over a thirty-year period. At a 2% rate of inflation, a lifestyle costing $100,000 a year today would cost $181,000 a year in thirty years’ time. Bumping up the interest rate just a quarter point to 2.25%, that number jumps up to $195,000 a year, a difference of 7.6%. This means you would need to generate nearly an additional $17,000 pre-tax each year in order to achieve the same lifestyle.
For someone with a $200,000 per year lifestyle in today’s dollars assuming a 2% inflation rate over the next 30 years, your lifestyle will cost $362,272. A 0.25% increase in the inflation assumption adds an additional $33,127 in required pre-tax income. Assuming a 4% growth rate on assets, you would need over an additional $725,000 in investment savings just to cover the difference in inflation rate, and even that would only cover you for 25 years before the money runs out.
Even if you have enough money to retire at whatever age you end up retiring, the drum beat of inflation continues to march forward. At a 2% inflation rate, the $100,000 per year lifestyle today that will cost $181,000 a year in thirty years’ time will now cost $269,000 twenty years after that. Adding just a 0.25% inflation difference, that number balloons to $304,200 in annual income required.
Gender Inequality is Exacerbated by Inflation
Moreover, while Americans in general are living longer than they did in decades past, women are living much longer. By the time millennials reach age 65, we believe that a woman will have a greater than 50% chance of living to age 90 and beyond. Health care costs and supplemental services such as housekeeping or assisted living at an advanced age tend to be much more expensive and have historically inflated at a greater than 4% rate every year for the last 40 years.
Income inequality also weighs in heavily in this discussion. According to the Government Accountability Office (2022), “women earned an estimated 82 cents for every dollar that men earned” in 2021. Additionally, women continue to bear negative earnings consequences by potentially having their careers disrupted if they have children; the “motherhood penalty” accounts for $16,000 a year in lost wages according to the National Women’s Law Center (May 2018). Inflation affects everyone, but not equally – women carry both more earning risk and more risk to run out of money than men.
The Punchline – 2% is Likely a Bad Inflation Assumption
While the Federal Reserve and global monetary leaders have their eyes set on a unified 2% inflation target, the reality is that over long durations of time, that number has never been achieved without extraordinary monetary policies in place. For example, during the last 20 years, the mean inflation rate has been 2.1%. However, over half of that timeframe was dominated by historically low interest rates stemming from the collapse of the banking system and the housing crisis – the Fed funds rate was below 2% from September 2008 until October 2018. Mortgages had historically low interest rates, but by the same token savings accounts offered a negligible amount of yield. Go back to decades prior to 2000, and all you will find are higher inflation rates and higher Fed Funds interest rates; the 1990’s had a geometric mean 3.1% annual inflation against a 5% Fed Funds rate, and the 1980’s had a geometric mean of 5.5% annual inflation against a 9.5% Fed Funds rate. The idea that a 2% inflation rate can be sustained for a long period of time is an unlikely and unreasonable assumption. We believe that a long-term rate of 2.5%-3% is a far more likely rangebound.
Conclusion – A Plan With Multiple Scenarios and Dynamic Analysis
This discussion stresses the importance of financial planning not as a one-off exercise, but rather as a perpetual analysis that digests new information as the months and years progress and adjusts the plan accordingly. However, the plan cannot be purely based on one line of analysis. As we have demonstrated here, even shifting just one variable a slight amount can have enormous longer-term ramifications. But there are many variables to account for, and everyone has their own unique set of opportunities and challenges. This is why it is vital for financial planning to be an ongoing, consistent relationship and process with a team of professionals that have a deep understanding of who you are and a perspective that builds multiple gameplans for the long run.
Bureau of Labor Statistics. (2023). CPI for All Urban Consumers 12-Month Percent Change [Dataset]. https://data.bls.gov/timeseries/CUUR0000SA0L1E
National Women’s Law Center. (2018, May 23). Mothers lose $16,000 annually to the wage gap, NWLC analysis shows – national women’s law center. Retrieved February 26, 2023, from https://nwlc.org/press-release/mothers-lose-16000-annually-to-the-wage-gap-nwlc-analysis-shows/
St. Louis Federal Reserve. (2023, February 1). Federal funds effective rate. Federal Reserve Economic Data. https://fred.stlouisfed.org/series/FEDFUNDS
Women in the Workforce: The Gender Pay Gap Is Greater for Certain Racial and Ethnic Groups and Varies by Education Level. (2022, December 15). U.S. GAO. https://www.gao.gov/products/gao-23-106041