Friday, December 14, 2012

Inflation Concerns at Retirement


Dear Investor Juan,

Retired 75 years old without any employment and business seeks help to make money from life saving and SSS pension.

I am really concerned about inflation, and I started reading about how to make money by investments, but I am really lost specially since there is a recurring warning all the time that I must be ready to lose all my life saving and accumulated SSS pension payments.

It seems that the only way to make money safely is to open savings accounts in banks, but the interest earned is so meager that it is not going to outpace inflation in any significant manner.

Are people like myself condemned to be eaten up by inflation so that they will if they live long enough end up penniless owing to inflation and of course from using up their life saving and SSS pension to continue meeting everyday life expenses as they continue in life?


Dear Marius,

I'll start by briefly discussing inflation in general. Then we'll go through alternatives that people in your situation can turn to to lessen its effects.

Inflation is the tendency of prices of goods and services to increase over time. It is a cause for concern because rising prices reduces how much of something we can buy with a given amount of money. And the less we have of something, the less of it we consume--and typically--the less happy or satisfied we are. And that can't be good.

That's not to say inflation is "bad," per se. Price increases are a part of life, and sometimes even favored and targeted in economic planning. If inflation is caused by increased demand, such as during an economic expansion, then it's good for everyone, on average, since it would be accompanied by low unemployment and proportionately higher wages which counteract the negative effects on spending and consumption.

However, retired individuals like you and others without regular income would be more affected by rising prices. Ideally inflation should be accounted for in financial or retirement planning to make sure that there would be enough money for needs and wants after accounting for inflation. The primary objective of any financial planning exercise is to have enough to cover expenses while one is still alive, and some subjective terminal amount at the end of the planning horizon.

When is enough enough? Technically, "enough" means that the present value of all cash inflows (e.g., retirement pension) and cash and disposable assets at hand should at least be equal to the present value of all future spending and some terminal value/amount. In equation form, it should look like:

cash + disposable assets + PV(pension) >= PV(spending) + PV(terminal amount)

(For a more detailed form of this, please refer to the spreadsheet in this post.)

At retirement, our objective is for the left side of this equation to be greater than or equal to the right side. Inflation increases PV(spending) and the right side of the equation, so it's a cause for concern. Fortunately, this simple model also shows us alternatives that can help us achieve our objective.

1) Invest appropriately. At this stage, your investment should be to earn returns while preserving capital and liquidity. While high expected returns would significantly decrease the right side of the equation (more than it will decrease the left side), it would also entail unnecessary risks that might erode capital and/or limit liquidity. This means inflation being greater than investment returns is pretty much a given at this stage of our lives, but it should not matter as long as our primary objective is met.

2) Control spending/expenses/comsumption. If last year you can buy five apples with your 100 pesos, and now you can only buy four, then maybe you should try to be satisfied with four.

3) Earn extra income. I know it must suck if we have to do this just to make ends meet at this stage of our lives, but we can just think of it as penance for making bad decisions in our youth.

4) Minimize terminal amount. In my opinion this should be zero. Only reason why it should be anything else is if you want to leave your children and grandchildren with some inheritance. But if you're worried that you don't even have enough to cover your needs for the remainder of your life, saving for your descendants' inheritance is a luxury that you can't afford.

I guess what I'm really trying to say is that instead of being overly worked up by "ending up penniless" or by inflation outpacing investment returns or by "using up" life savings (what else are savings for but to use up?), we should be more concerned with making sure that we have the means for a good-quality of life while we're still alive to enjoy it.

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