As stated in my previous blog there are many risks faced by investors in retirement. The issue I want to address next is inflation.
I think it is important to first understand what inflation actually is. The most simplistic explanation is a rise in prices, that is, what we as consumers pay for our goods and services.
Inflation actually represents a situation where demand for goods and services actually exceed their available supply in the economy ( Hall, 1982). An example of this might be where there is a shortage of oil (or even a perceived shortage). This generally leads to increasing prices as the demand exceeds the available supply. Another cause of rising prices and perhaps a flow-on effect is when costs to business to produce goods and services rise. For example, cost of iron ore to produce steel leads to higher building costs as does cost of coal to produce power. We have seen how China’s appetite for these resources leads to increased prices. As economies grow there is also a demand for higher living standards, and this usually accompanied by higher wages again leading to higher end prices which is inflation.
How does this impact a Retired person?
A retired person can actually be on a fixed income and as a result, as prices rise their purchasing power reduces. For example, if a fixed income retiree had an income of $500 per week and prices rose by 4% over a period of 5 years the retiree has lost on average 20% of their purchasing power. This in turn means that living standards will drop over time as prices for essential items rise and income stays stagnant. Another simple example of how inflation works on purchasing power is if you were to invest in a term deposit or government bond at say 5% and inflation or price movements were 4% your real return would be 1%. That is the difference between the inflation rate and the investment rate.
How can we combat this?
This is where sensible financial planning can assist. The most effective way to curb the effects of inflation is by investing in what we refer to as growth assets, and they are generally in the form of either shares (both domestic and international) or property assets. On average, based on historical performance these assets generate a higher return than inflation, thereby maintaining our living standards. The issue here is that these asset classes bring inherit risks i.e. their value can actually reduce. Having said that, over the longer haul the opposite is generally true. The importance therefore is having a balanced and diversified portfolio of growth assets that if well managed can reduce investment risks whilst at the same time curbing the effects of inflation on our living standards.
A qualified financial planner will be able to help you construct an investment portfolio that addresses risk of inflation eating away your living standard.