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November 2009 Update

November 5, 2009

By Tim Chapman

Returns vs. Real Returns

The Impact of Inflation on Retirement

Would you be excited about getting 21% interest on a money market account? Banks were paying those types of returns on money markets and CDs in 1981 and investors thought they were making out like bandits. But they weren't. The reason why? Inflation was in the mid-teens, which means the real rate of return was only 5-6%. Most investors focus only on market risk - buying something and hoping it doesn't go down. But the greater risk is having prices, over a very long term, go up more than your spending power.

Nominal vs. Real
The 21% rate was the nominal rate of return, but what really matters is the real rate of return. That is the rate you are earning minus the rate of inflation. So if inflation is 18% per year, and money markets are paying 21% per year, the real rate of return is only 3%. It would be the same as earning 5% when the rate of inflation is 2%.

Think of it this way. Instead of money, let's use corn as our "currency". You can do three things with an ear of corn: you can eat it, you can put it in a silo to eat it later, or you can plant it to grow lots more corn. Money is like corn. You can spend it right now, you can put it in a savings account (short term) to spend it later, or you can invest it (long term) to create lots more money. Sticking your money in a money market account is like putting corn in a silo. You don't really expect it to grow, you just hope it outpaces inflation so when you take it out you can buy the same amount of groceries, in real terms, that you could've bought originally. That is why the real rate of return is so important.

Imagine the frustration of stashing money away in a "guaranteed" account, only to find it wouldn't buy as much when you finally get around to spending it as it would've in the first place. Inflation risk is a hidden, insidious risk, and yet it is the greatest risk most Americans will ever face. You could save a million dollars but if Snickers bars cost two million dollars, you really don't have much money!

Inflation and the Rule of 72
The Rule of 72 is interesting. If you divide a rate of return into the number 72, it tells you how long it takes money to double at that rate. For example, if you earn 9% on a $100,000 account, it will be worth $200,000 in 8 years; $400,000 in 16 years; $800,000 in 24 years, etc.

If you apply the Rule of 72 to inflation - your cost of living - it can be pretty eye-opening. Let's assume you are living comfortably at age 50 on $60,000 per year. If inflation averages 4%, at age 68 you would need $120,000 just to maintain the same lifestyle. Too many people plan for retirement as though it was a fixed moment in time, but that's a mistake because life doesn't stop just because the paychecks stop. The cost of milk, bread, and eggs continues to go up even after you've retired! That is why it is so important to get a reasonable real return on your retirement nest egg so you can stay a step ahead of the cost of living, i.e. inflation. Bill Gates and Warren Buffet could put all their money in a 3% CD and live the next 30 years just fine; the average American cannot. In my 28 years in this business I've seen too many people who were comfortable at age 60 but struggling to pay the monthly bills at age 75 because their "guaranteed" accounts were not keeping up with inflation.

Inflation and the Stock Market
Inflation has a negative effect on stocks too. As inflation goes up it drives interest rates up. (Who would accept a 6% rate of return on a money market if inflation was 8%? That would be a negative real rate of return.) Higher interest rates mean it costs a company more to borrow money to build new plants, expand employment, etc. That increased cost impacts the bottom line; lower earnings means lower stock prices. In addition, higher interest rates can cause investors to choose bonds over stocks, further depressing stock prices.

Of course there are some sectors of the economy that benefit from an inflationary environment: commodities (corn and wheat), precious metals (gold and silver), foreign currencies (Japanese yen and Euro), and real estate.

The great thing about being a tactical, unconstrained manager like Stadion, is we are free to buy any sector of the market. So, in a hyper-inflation environment, traditional money managers might be punished in the equity markets. However, our portfolios could benefit from utilizing the non-traditional asset classes like those named above.

Are We Headed for Hyper-Inflation?
I don't know the answer to that question and I don't even pretend to know the future. But this I do know: It is critically important for investors to outrun inflation, and it is reassuring to know that we have the latitude to adapt our portfolios to 1) protect against the downside and 2) take advantage of any economic environment.