When inflation takes off

LOOKING back in time, what could you buy for $5? Without a doubt, a lot more than what you can today. Why? The answer is inflation, and it is poses a risk to your retirement fund if you have not considered it in your plans.

Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as an annual percentage increase. As inflation rises, every dollar you own buys a smaller percentage of a good or service. As American baseball player Sam Ewing once said, "Inflation is when you pay fifteen dollars for a ten-dollar haircut you used to get for five dollars when you had hair”.

When planning for your retirement, it is important to factor in inflation. If you don’t take inflation into account, you are going to put yourself in a position where you might be able to afford to live today based on the amount of money you have, according to Personal Wealth Advisers principal Cameron Howlett. “But in five years time you might not be able to afford the same type of lifestyle you did five years ago [because the cost of living has increased],” he said.

For example, in today’s dollars, if you need $35,000 a year to live, then in 10 years time if inflation was at 3% you would need $47,037 to have the same standard of living. The Reserve Bank of Australia has an inflation calculator to give you an idea about how much money was worth in the past and what it is worth today.

How do you factor in inflation when planning for your retirement? Howlett says it is important to diversify your investments.

“Don’t put all your eggs in one basket,” he said.

“The issue with investing all your money in just cash assets is that you are never going to get any capital gains or growth, assuming you are taking the income to live, which in real terms will reduce the value of your money” Howlett said. “Growth assets like Australian shares, for example, over time should go up in value and could generate the type of income you might need in five years time.” Another type of growth asset is property, even though it does pay income in the form of rent. Howlett said over time, your expectation would be that the property’s value would increase in proportion with the growth in Australia’s gross domestic product.

Howlett said the plan to fund a retirement would be different and depend on the individual. “For example a client in their 40s probably won’t need an income, but may need capital growth to fund a retirement,” he said. “So in this case you would look to invest more of [their] money into equities as [he] has a while before retirement.”

“However, if the client is retiring and they need $50,000 to $60,000 a year in income and they have $1 million, we would split it up,” he said. Some of the money would be invested in cash assets and some of it in growth assets like Australian shares and or property, which hopefully over time will go up in value as well as pay dividends or rent. Howlett said this should help the individual meet their living expenses and manage inflation over time.

A failure to factor inflation into a retirement plan is common, according to Howlett. “You see it quite often. Just recently I had a case where someone retired six years ago and had only put their money in term deposits,” he said. At the time of the original investment, the person was receiving a good interest rate for the term deposit, but as their cost of living went up, the client had to draw down from their capital to meet their increasing living expenses. This is a direct result of not diversifying their investment into some growth assets when they first retired.
Howlett says it is not a bad idea to sit down with a certified financial planner to asses and plan the best way for you to enjoy a comfortable retirement.