How To Protect Pension Income from Inflation
October 21, 2003

How To Protect Pension Income from Inflation

Workers with pensions--- a slowly vanishing breed--- have a unique problem.

They literally live on a "fixed income."

Their monthly pension benefit is based on how many years they worked, their final average salary, their age, the age of their spouse, and their employers' benefit formula. After that, the checks roll in, month after month.

And the checks are always the same.

They are the same regardless of changes in the price of food, gasoline, insurance, real estate taxes, or medical care. As a consequence, many pensioners feel well off when they retire but soon feel the pinch of rising prices. Over 25 years--- the joint life expectancy of a typical couple--- a pension that was worth $10,000 a year will see its purchasing power slide to only $4,776 if inflation runs at the long term average rate, 3 percent.

Recent history is worse. A person who retired twenty-five years ago with a pension of $10,000 a year would have lived through a compound annual inflation rate of 4.4 percent a year. This would have reduced his original purchasing power to only $3,408.

Query: Is there a safe way to use other savings to compensate for inflation?

Yes. It's another good use for I Savings Bonds. (Alternatively, you can use an IRA rollover account to hold a mutual fund that invests in Treasury Inflation Protected Bonds. This will provide inflation protection but it will also have market ups and downs.)

Suppose, for instance, you wanted to protect the purchasing power of $1,000 of annual pension income for 25 years. How much would you have to invest in I Savings Bonds that returned 1.0 percent annually over an inflation rate that averaged 3 percent? Answer: $6,070. That figure comes from a handy little spreadsheet that I built to calculate such things. If you could get a 3 percent real return over a 3 percent inflation rate you'd need less, $4,546.

How do you use this information?

Simple. For every $1,000 a year of pension income, you'll need an Inflation Protection Fund' of $4,546 to $6,070. If your pension is $20,000 a year, you'll need about six times as much--- $120,000--- in I Savings Bonds to maintain your purchasing power.

What if your retirement isn't "average" and inflation is higher?

Well, it could be. Deflation angst notwithstanding, most people are experiencing inflation in their cost of living. The worst inflation we've ever had since 1926, according to figures from Ibbotson Associates, was in 1946. It was 18.15 percent that year.

Fortunately, the longer the time period you measure, the lower the annual rate of inflation. The worst 5-year period for inflation was 1977-1981, at 10.06 percent a year. The worst 10 year-period was 1973-1982, at 8.67 percent. The worst 15-year period was 1968-1982, at 7.30 percent. And the worst 20-year period was 1966-1985, at 6.36 percent.

For 25 years, the figure is 5.9 percent.

If history is a guide, this means you'll need $9,814 in an inflation protection fund for each $1,000 of fixed income if your return over inflation is 1 percent, $8,538 if your real return is 2 percent, and $7,460 if your real return is 3 percent. Here's what it looks like as a table:   

Investment Needed To Protect Purchasing Power of $1,000 Pension
In order to offset the effect of inflation on a fixed income over a period of 25 years, a conservative investor would buy I Savings Bonds in the amount calculated below. The real return on common stocks is higher, about 7 percent, but it is far more uncertain.
Annual Inflation Rate 1 Percent Real Return 2 Percent Real Return 3 Percent Real Return
3.0 Percent (Long term average rate) $6,070 $5,281 $4,546
5.9 Percent (Worst 25 year period) $9,814 $8,538 $7,460
Source: Scott Burns' inflation immunization model

Needless to say, you can forget all of this if there is no inflation in the future. Mention price stability to the Goddess of History and she will roll her eyes.

Then she will smile and offer you a bridge in Brooklyn.  

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