Don't forget to consider inflation in your investment strategy or risk getting caught short.
Inflation causes distortions and problems in many areas of a market-based economy like Australia.
So it’s a good thing that over the last 10 to 15 years, it has been quite low. The problem with a low inflation rate is that it seems to have made many retirees complacent about its potential impact on their future lifestyle.
In my view, inflation is the biggest problem retirees face. It’s a bigger problem than running out of money.
Prices rise threefold
In the last 30 years, the Australian Bureau of Statistics has estimated that consumer prices have increased by a total of 292 per cent. That is, prices have gone up almost three times.
This result actually surprised me because I didn’t realise it was this high.
To help you understand what this means, here’s a simple example. Today, many of us would spend about A$3.50 on a cup of coffee. Thirty years ago, based on this data, we would have only spent A$1.20.
Obviously, some prices of consumer goods over that time have increased faster than this rate (for example, private health insurance), whereas others have fallen over this period (for example, some international air travel), while still others haven’t changed too much.
This 292 per cent increase is an average rise of about 3.7 per cent a year over the 30 years, which doesn’t sound too high.
However, most of these price increases occurred in the 1980s, because in the last 10 years prices have only increased by 31.4 per cent.
Income needs to grow faster than inflation
The Association of Superannuation Funds of Australia (ASFA) estimates how much income retirees need to have a reasonable retirement.
For the end of December 2004, ASFA said that a couple would need A$43,350 and singles A$32,800 per annum to have a so-called comfortable retirement. Importantly, these numbers assume you own your retirement home.
By September 2013, these numbers had increased to A$56,404 and A$41,197, respectively.
In percentage terms, these are increases of 30 per cent for couples and 25.6 per cent for singles. Since 2004, ASFA has revamped its assumptions about how retirees spend their money because how we spend our money has changed. During the last 10 years, for example, people have been spending more on communications, such as mobile phones and the internet.
Over the same period, the official consumer inflation increase has been 27.6 per cent. ASFA is saying that the income needed by retired couples has had to increase slightly faster than the inflation rate.
In its latest announcements about this retirement income data, ASFA says that recently there have been quite significant increases in electricity prices, property rates and charges, and water and sewerage charges. On the other hand, food and private health insurance costs were reasonably stable.
If inflation averages 3 per cent a year over 24 years, then prices will double. Obviously, during the intervening years, prices are also on their way up.
Assuming average life expectancies, health, occupations and leisure pursuits, anyone retiring before age 70 needs to assume that they will live for at least another 25 years.
Prepare for it
In my view, inflation is a slow, debilitating disease and unless retirees take action to allow for it, they run the real risk of going backwards. Because the drop in purchasing power occurs so slowly when inflation is low, there’s a real risk you might not notice it until it’s too late and your standard of living is forever adversely affected.
Retirees need to think very carefully about what type of asset will generate income that increases faster than inflation so that they avoid its impact. Just as employees look for jobs that provide for regular wage increases to improve their standard of living and protect against inflation, retirees need their assets to deliver the same result.
Tony Negline has worked in financial services for more than 25 years and has been heavily involved in self-managed super funds since mid-1994. He writes about SMSF matters for a wide range of audiences including accountants, auditors, financial advisers and SMSF trustees.