I was recently asked during a presentation why I think inflation is a bigger curse for retirees than workers.

I have several reasons. Firstly, workers generally deal with inflation automatically because their wages increase over time. Obviously, some people are better at negotiating wage increases than others, but that’s not the point.

While working, we use our mental and physical labour to earn a living. Once we retire, we cease using our skills and begin to rely solely on the ‘labour’ of our investments to generate our income needs.

Cost of living increases

Unfortunately, inflation doesn’t magically stop when we stop working and many of us will be retired for at least 20 years, if not longer. So if inflation averages 3% per annum over, say, 24 years, then prices will double in that time.

Unlike workers, retirees have no one to negotiate with when they need an increase in income to take inflation into account.

The added danger with inflation for retirees is that it’s awful impact is ignored until the horse has bolted.

How much cash do you need?

For example, the Association of Super Funds of Australia (ASFA) estimates that a couple would need over $55,000 per annum – or about $1,060 per week – to have a comfortable retirement.

When planning, many people work out how they might generate that level of income over the medium to long term. It is a common mistake that over 20 years, many people would try and pay themselves about $1.1 million in income (20 x $55,000 = $1.1 million) – without taking inflation into account.

This is a fundamental mistake. In this example, we would actually need almost $1.5 million in income, assuming inflation is 3% each year, in order to maintain purchasing power over twenty years.

Planning ahead

So how do retirees build inflation into their retirement planning? Generating inflation-linked income over the indefinite long term is the really complex part of retirement planning.

It’s made significantly more complex because we’re a nation obsessed with capital values. Every investment is discussed from the point of view of its value and not really from the income it might generate. Ideally, we want to buy an asset for $1 and thirty minutes later sell it for $5.

To put it another way, we’re a nation of optimistic upside speculators. In reality, this attitude makes life very difficult for retirees trying to generate inflation-linked income.

If you’re trying to pay yourself income using capital values as your major focus, then I can guarantee that you’ll run out of money very quickly. Take the following simple example, which comes from my book on self-managed super funds:

Example

Suppose an investor puts $100,000 into a managed fund that has a $1 unit price, which means they ‘own’ 100,000 units. Suppose that after several years the unit price has increased to $2. Their 100,000 units are now worth $200,000.

If the investor wants to pay themselves $10,000 in income from this fund, they would need to sell 5,000 units while the unit price was $2.

Now suppose the unit price crashes to 75 cents, but they still wish to pay themselves $10,000 in income. They will now need to sell 13,333.33 units.

Under this second scenario, units are literally walking out the door as income. This problem is exacerbated because fund managers must value all their assets at the prevailing market price.

Two lots of $10,000 in income have seen almost 20% of the person’s retirement assets disappear. Not a great long-term strategy.

This problem is also exacerbated because some fund managers constantly turn portfolios over as they try to generate investment returns by taking positions (or bets) on constantly changing asset prices.

Increasing income is key

In this complex environment, we can’t put our head under the bed covers and hope the problem will disappear.

We need to construct a portfolio that generates increasing income over the long term. We can’t do this by focusing on the current yield (or income return) of an asset because it often gives no guide about future income.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.