I’m often asked what is the biggest threat people face in retirement. There are many issues to choose from and healthcare expenses are near the top of the list. However, our ever increasing life expectancy still makes inflation the biggest problem facing retirees. The latest announcement from Social Security underscores this issue.
The Social Security administration announced the cost-of-living (COLA) increase for 2014 will be 1.5%. If you thought last year’s 1.7% COLA was small this one will amount to about $19 per month. Social Security bases their COLA on the Consumer Price Index (CPI) which showed an increase of only 1.2% over the last 12 months largely due to a drop in gas prices. Unfortunately, medical expenses were up 2.4% in the same period and health care is typically one of the largest expense categories for most retirees.
The good news was the premiums for Medicare Part B will remain the same in 2014. Premiums increased to $104.90 for most seniors in 2013 with a $147 deductible. These amounts will hold through 2014. Most seniors have the Medicare premiums deducted from their Social Security benefits so they actually will see an increase in January.
Source: Social Security Administration
COLA increases have been anemic over the past five years as inflation remains under control while the economy recovers. This has made it difficult for retirees who have expenses increasing much faster than CPI. This spring, President Obama proposed changing the way COLAs are calculated by using chained CPI going forward. If adopted, chained CPI would slow COLA increases even more. This would help the government reduce future deficits but it puts more pressure on retirees to find other ways to increase their income throughout retirement.
A healthy 65-year old couple can look forward to a joint life expectancy of 25-30 years. Moderate inflation of 3 ½% per year would nearly triple the cost of living over their golden years. Social Security COLA adjustments will not be able to handle this alone. One of the best ways to fight inflation is through your investment portfolio. Each year some of the return is reinvested to keep the principal growing. Ideally the amount reinvested every year will equal the rate of inflation. Any growth over inflation could be spent without putting your financial future at risk.
This strategy cannot work with a portfolio investing entirely in fixed income. Good quality fixed income investments barely match the rate of inflation. The best rate on a 5-year jumbo CD was recently 1.98% according to Bankrate.com. Allowing 1.5% to reinvest to fight inflation would leave very little of the remaining yield to spend. A retiree would have to have a huge nest egg to produce enough excess return to support a modest lifestyle.
Wharton Business School professor Dr. Jeremy Siegel’s research has shown investing in equities has been the best way to fight inflation. The fourth edition of his book Stocks for the Long Run looks at the return of the financial markets starting in 1802. Dr. Siegel shows how equities have produced a return of 6 ½ to 7% after inflation over the past 200 years. No other investment – bonds, gold, real estate – even comes close to the return of equities after inflation.
The reason equities do well is because they represent ownership in companies which can adapt to changes in the economy and the consumer’s buying habits. Not all companies succeed which is why retirees should own diversified portfolios. Portfolios should be diversified within investment classes and among the different investment classes. For example, a portfolio would own equities of US companies as well as those overseas. The companies should include large well established companies as well as newer companies on a steeper growth curve. The strategy should be to have broad enough diversification so that some part of your portfolio is doing well in any market.
Today’s retiree can maintain their lifestyle throughout their golden years. However, it will take a cohesive investment strategy to provide the growth they need for the future along with the income needed for today.
- Social Security COLAs are based on CPI which doesn’t always reflect a retiree’s actual increase in expenses.
- Inflation of 3 ½% would nearly triple the cost of living over a 30 year time period.
- Jeremy Siegel’s research has shown stocks have had the best return after inflation over the past 200 years.