Monday, April 30, 2007

How to whip inflation now and retire happier.

Inflation has a corrosive effect on retirement savings. To illustrate, let's assume you are diligently saving $10,000 a year in a retirement account like a 401(k), and your retirement savings earn 7% a year. After 30 years, you'll have a bit more than $944,000--almost millionaire territory. If you can stand another year in the work force, you'll be a millionaire. (We're using the calculators at to get our numbers.)

But let's assume that over those 30 years, inflation runs at 3% a year (which is about its historical average for much of the 20th century). In that case, your savings would have a value of almost $379,000 on an inflation-adjusted basis. That's better than soggy fries with your burger, but you're a long way from being a millionaire measured by today's dollar.

Inflation was once an episodic event in America, and tended to coincide with exceptional economic stresses like wars. We actually had price deflation after the Civil War, again after World War I and yet again in the 1930's during much of the Great Depression. Since World War II, however, inflation has become virtually endemic. While its causes are much-debated, the fact is that inflation has, like an infestation of termites, taken up residence in our lives.

So how do you prevent inflation from eroding the foundation of your finances? Think judo. In judo, you use an adversary's momentum as your weapon. When an attacker charges at you, you slip to one side and flip him over your leg or hip.

Inflation creates price momentum. It pushes upwards the prices of goods and services you buy. But it also exerts upward pressure on the price of labor (i.e., wages and salaries). As the prices of goods and services go up, employees demand higher compensation to cover their increased costs of living. Much is discussed today about how the distribution of wealth is becoming more unequal and how median household income in America has stagnated, and perhaps even dropped. Nevertheless, household incomes for most workers tend to keep approximate pace with inflation.

To protect against inflation, boost the amount you save for retirement by the rate of inflation. Your rising income allows you to finance these increases. Your retirement portfolio will grow correspondingly faster, to give you a buffer you'll need. Following the example used above, save $10,300 in the second year of your retirement savings plan (i.e., 3% more than year one), $10,609 in the third year (i.e., 3% more than year two), $10,927.27 the fourth year (i.e., 3% more than year three), and so on. Even if your income doesn't always keep pace with inflation, accept a minor reduction in your current lifestyle, and continue to increase your savings in line with inflation. Start this process now, keep it up as long as you work, and you'll sleep better for many years.

Sometimes, the IRS's limits on contributions to retirement accounts (like 401(k)s and IRAs) don't always increase as fast as inflation. In that case, save more in taxable accounts. The retirement account contribution limits simply define the amount of tax sheltering effect you'll get and don't have any necessary relationship to your financial needs or goals. Don't let government tax policies dictate how much you'll have in your golden years.

Strange News: Even though we can explain how to protect yourself against inflation, we can't explain Phil Spector's wig:

For more personal finance ideas, check out this blog carnival:

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