Inflation is defined as a general increase in prices and a decrease in purchasing power.
For anyone nearing retirement, the threat of inflation presents a nightmarish scenario; fixed income being eroded in purchasing power value.
A majority of financial advisers across Ireland approach retirement from a financial accumulation perspective but not enough focus is placed on the devastating impact of inflation. And while inflation has been extremely muted in recent decades, it is something that always lurks in the shadows. To some degree, we all benefit from inflation as it represents a functioning economy; the European Central Bank targets inflation of about 2% as its key measure.
Across the world, especially in developed countries, inflation is an economic weapon that could be deployed to create a financial escape hatch for municipal authorities trapped by unattainable pension obligations. Without it, they will be forced to raise taxes, redirect funds from current spending or default in the years and decades ahead.
But back here to Ireland, what if inflation did tick upwards and become a more prominent feature of our day-to-day lives.
The decreasing value of today’s money in the future
Let’s say you have €40,000 on deposit with a bank or credit union today. You leave it on deposit because you cannot get a mortgage to purchase an investment property and you don’t fully understand stock-markets, bonds, mutual funds or alternative investments or the risk they carry. It takes a lot of working hours to accumulate €40,000 from net income. So, deposits are cash, cash is king and you can get it when you need it. Or that is what you tell yourself. But in reality, cash in this case is a leaking ship that is sinking in value. Here’s why.
Let’s say for a moment that inflation is running at 2.5%. This means the value of your money is eroding at 2.5% per year. So, in the first year you have that €40,000 on deposit, you lose €1,000 of it through inflation. If you had taken that €1,000 and burned it, you would see that loss immediately but because inflation is a silent killer of the value of money, you don’t notice it. It’s like natural gas; we can’t smell it or see it but it has a devastating impact all the same.
Each year, that pot of money falls in today’s value.
If we consider the value of the money over a 20-year period, the loss continues and the purchasing power value of that €40,000 in today’s terms continues to fall each year.
The value of €40,000 in today’s terms will fall to just €24,410 in 20 years time if inflation remains at 2.5%. In other words, in 20 years time, that money will only buy you what €24,410 would buy you today. It would be the equivalent of walking into a shop today, handing over €40,000 to purchase €24,410 worth of goods and receiving no change.
Inflation is a corrosive force on the value of money and it is what every money manager worth their keep should be striving to counter if they really do put the financial wellbeing of their clients first.
If inflation rises to 3%, what happens then?
Using that same €40,000 example, if inflation were to rise to 3%, the value of today’s money falls to just €22,147 or in percentage terms, it decreases by 45%. In other words, the value of the money decreases by almost half.
OK, but how much will you need in the future?
This should be a major concern for anyone remotely considering their future financial needs.
If we take someone today that requires an annual income of €40,000 to live, to have a home, pay for day-to-day living costs, in order to enjoy the same standard of living in 20 years time, assuming for inflation at 2.5%, they will need €65,544.
For someone still in employment, that might be achievable through wage inflation. However, for anyone in retirement, on a fixed income, even if they are financially comfortable today, they face the real prospect of a fall in living standards. Don’t be fooled by those that might argue that mortgages will be repaid and kids will have all flown the nest and become financially independent. In reality, other life factors come into play; health is a major one.
What if inflation is greater than projected, how much will be needed?
If inflation rises to 3%, that €40,000 you need today grows to €72,244 in 20 year’s time. If you need €50,000 today, at 3% inflation, you will need €90,305. The numbers only go one way, up!
The future will always present risk. Some of it can be mitigated through financial planning. For example, the biggest financial risk in retirement comes with the cost of medical care, one can have medical insurance but there will be out-of-pocket expenses which can add up and drain a fixed income depending on the medical condition. Across the world, authorities are recognising the impact rising healthcare costs are having on public and private services. A major factor in those costs derive from lifestyle health issues, including obesity, diabetes, high blood pressure and heart disease; health issues that are easy to manage and control through diet and exercise.
For those seeking a relatively comfortable life in retirement, they need to consider what they can plan for. When it comes to their financial needs, they must factor for inflation and at current returns, placing money on deposit will not keep pace with modest levels of inflation; investing can, provided it is managed efficiently. They should also bring their long-term health situation into their plans and look for ways of limiting a potential financial black hole.
Frank Conway is a Qualified Financial Adviser and Founder of MoneyWhizz.org