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SJul 3, 2005

Pensions and Inflation (part 1): The High Cost of Modest Inflation

Imagine this. You're in your late 50s. You've been working for the same company for a long time. You're in pretty good financial shape. You've paid off the mortgage. You have a nice balance in your 401(k) plan. You have some modest savings outside the plan.   

And, miracle of miracles, your company has a defined benefit pension plan.

Better still, top management at your company has done a pretty good job of funding the plan. They resisted the temptation to squeeze its funding so they could realize millions on their stock options.

So you've got a pretty good shot at actually collecting.

How quaint.

If this is you, consider yourself blessed. You can move to the Fool's Paradise known as early retirement.

Here's how you might get there. First, your employer makes an early retirement offer. The offer is likely to include cash severance and some sweetening of the pension plan. Maybe even a medical insurance bridge to age 65. When you add it up, it looks like you'll have a big surge of cash in the bank. And the combination of early Social Security and the pension will support your current standard of living.

What's not to like? You've just been given a ticket to a life of leisure. In the last two decades millions of Americans have taken this ticket and moved to Fool's Paradise. Those who moved earliest are beginning to realize they have a problem.

It's called inflation.

This is not the inflation of the policy wonks, the people who worry about the dollar and other global things. This is the inflation of toothpaste, hamburger, real estate taxes, electric bills, and car repairs. Over the last ten years we have celebrated the decline of inflation, talked about "disinflation," and worried about deflation. In fact, the consumer price index--- the broadest measure of general inflation--- continues to rise at a healthy rate. According to the Bureau of Labor Statistics, it's running at a 3.5 percent rate currently. Over the last five years that rate has ranged from a high of 3.8 percent (2000) to a low of minus 1.3 percent (2002).

That modest 3 percent amble guarantees that our children and grandchildren will consider prices we mention amusing, just as Cokes for a nickel and coffee for a dime seem today. At 3 percent a year, today's $2.94 visit to Starbucks will cost $6.16 in 25 years--- more than double.

So what happens to the early retirees on a fixed pension? They lose purchasing power. It's never dramatic. But it never lets up. A retired couple who cover half their standard of living with a fixed pension will lose 7 percent of their purchasing power in 5 years, 13 in 10 years, 18 in 15 years, 22 in 20 years, 26 in 25 years, and 30 in 30 years. The table below shows the impact of 3 percent inflation on households with 30 to 60 percent of income replaced by a pension--- all figures rounded to the nearest percentage point.

  

The Fixed Income Retirement Trap

This table shows the loss of purchasing power over different time periods at 3 percent inflation for retirees with different portions of the initial standard of living covered by a fixed pension. A retiree who replaces 60 percent of income with a pension will lose 22 percent of purchasing power in 15 years.
Year 30% 40% 50% 60% 100%
0 0 0 0 0    0
5 4 6 7 8 14
10 8 10 13 16 26
15 11 14 18 22 36
20 13 18 22 27 45
25 16 21 26 31 52
30 18 24 30 35 59
Source: Scott Burns calculations
  

Some readers will focus on the near term damage--- what happens in 5 or 10 years. That would be a mistake, particularly for early retirees. Today, a 55-year-old woman has a life expectancy of 27.7 years, a 55-year-old man 24.1 years. Considered jointly, one of them will live well beyond either individual expectancy.

Is this just more bad news in a world filled with bad news?

Hardly. This is what some would call   a "Cadillac problem"--- the most important fact is that we're living longer. How to pay for it is secondary. Better still, just as our lives are longer because we have better medical tools, we now have better financial tools.

This is a problem we can fix. All it takes is money.

Tuesday: Pensions and Inflation (part 2)--- Inflation Guarding Your Pension

Federal Reserve Bank of Minneapolis Inflation Calculator

Filed Under: Financial Planning, Income Investing, Retirement