Inflation is the silent killer of retirement dreams. It sneaks in over the years and nibbles away at nest eggs, leaving people poorer than they realize.
How does it do this evil deed? By eroding the purchasing power of money.
You can see inflation's impact in the rising prices of many goods and services over the past few decades. A generation ago you might have been able to buy a nice home for $50,000; the same house today might set you back $250,000.
To get a sense of the bite that inflation can take out of your retirement plans, let's start with a happy image you may have spotted in the office of your broker or financial advisor. It's the graph showing the long-term returns of the S&P 500.
Sure, the index bounces around, but the overall picture, as depicted in the accompanying graph, is mighty impressive. The S&P 500 managed to produce an average total return of 9.2 per cent a year since the early 1960s, which sounds more than big enough to satisfy most investors.
But that figure doesn't account for the impact of inflation. After that thief had his way, the pattern of returns follows the much lower line on the graph. Your inflation-adjusted return would have amounted to an average of only 4.8 per cent a year.
If you hadn't properly adjusted for inflation, you might have spent too much early in your retirement based on your deceptively high returns in nominal dollars and been left with too little purchasing power later on.
Inflation doesn't operate alone. It does its dirty work in combination with partners, like taxes and fees, that can cut additional slices out of your results.
Start with that 9.2 per cent return, take out a 2 per cent fee for the management of your mutual funds, pay a quarter of the gains in tax, and then see inflation run at 4.1 per cent and you're left with a return of about 1.3 per cent. That's not much to live on despite the market's apparently strong results before all these factors are taken into account.
And nothing is guaranteed. The market has a habit of falling into prolonged swoons, where inflation-adjusted returns fall below even these modest levels. Since the S&P 500 peaked in 2000, returns have actually been negative. There are other similarly long periods when the index declined in value after adjusting for inflation.
You can see the whole sad tale in the accompanying graph, which shows declines in the inflation-adjusted index from its prior peak level. While we are now in a bad patch, the 1970s and the 1930s weren't much fun either.
If the current downturn persists for a few more months, it will eclipse the 1973-to-1985 malaise in duration. Is it any wonder that more and more people are postponing their retirement these days?
Norman Rothery, PhD, CFA is founder of StingyInvestor.com
Norman Rothery