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The scourge of inflation

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 once thought.

How does it do the dastardly deed? By reducing the purchasing power of money over time.

You can see its 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 see the bite inflation can take out of your retirement plans, let's start with the happy picture you may have spotted at your financial advisor's office. It's the graph showing the long-term returns of the S&P500.

Sure the index bounces around, but the overall picture, as depicted in the accompanying graph, is mighty impressive. The index managed 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.

Graph of the nominal and real returns of the S&P500
[larger version]


But that figure doesn't account for the impact of inflation. After that sneak thief had his way, the return pattern 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 retirement based on the high dollar returns and been left with too little purchasing power later on.

Inflation doesn't work alone. It does its dirty work in combination with partners, like taxes and fees, that can take additional bites 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 very good return before all of these factors are taken into account.

Even worse, the market can go 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 also other similarly long periods when the index declined in value after adjusting for inflation.

You can see the sorry history in the accompanying graph which shows declines in the inflation-adjusted index from its prior peak level. While we are now in one such period, 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?

Graph of the nominal and real returns of the S&P500
[larger version]


First published in the Globe and Mail, January 14 2012.

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