As stated in the previous post, there are three competing concerns when managing money in retirement. These are:
- To generate enough income for expenses.
- To have the amount of money you possess grow over time so that you’ll be able to keep up with inflation.
- To make your money last for the rest of your life.
In the last post we discussed income assets and how to use them to generate the cash you’ll need when you’re retired. Today we’ll talk about the second element – making your portfolio grow so that you’ll be able to keep up with inflation.
Unfortunately, even if you stick all of your money in a safe deposit box or bury it in the ground, if your money is in the form of cash a little bit of it will be stolen from you every month. This is because the government is always printing a little more money than collected in taxes, causing inflation. Even if you deposit it in the bank or buy CDs you’ll be losing a little bit each month in terms of buying power because the interest paid by these assets is less than the rate of inflation. While inflation is typically less than 3% per year, over the course of a 30-year retirement inflation can easily consume half of your savings, meaning that you’ll only be able to buy half of the things each year after 30 years that you were able to buy when you started retirement if you withdraw the same numerical income each year from your portfolio. Inflation for things like food, energy, and healthcare can be even worse during some periods. For these reasons you need to place a portion of your money – money that you won’t need for a while – into investments that will keep pace with inflation, allowing you to grow your income with time.
One place that many people use is their home. If you are willing to sell your home at some point late in life, you can use the proceeds to pay for expenses. Because the value of the land under your home remains relatively fixed, or even grows as more people desire to live in an area, plus the cost of the materials required to build your home remain relatively fixed, your home should go up in price at about the rate of inflation or more. There are exceptions of course, such as living in an area that for some reason sees home prices decline due to a plant closing, natural disaster, or other event.
Your home is far from a perfect inflation hedge, however. One reason is that you’ll always need somewhere to live, so you’ll almost never be able to use the entire value of your home. The exception will be if you move in with relatives or if you trade your home to a nursing home in exchange for care there. A second reason is that homes always need maintenance, so the value of the materials in the home are always declining. People often think that they make a lot of money when they sell a home after owning it for many years, but they forget all of the money they spent on paint, shingles, upgrades, maintenance, and lawn care. A final reason that a home is not a perfect inflation hedge is property taxes. Really in many ways a home is most useful in at least getting people to save up some money that they can use later, but even then many people spend the money as quickly as they get it by taking out loans on their homes.
A second asset that keeps pace with inflation is land and investment real-estate. Again, owning land will require the payment of property taxes, but they will be far less than those owed for land with a structure most of the time. You might also be able to enjoy the land, such as having it as a private retreat for hunting, camping, hiking, or just sitting on a nice day. Investment real-estate, such as apartments or commercial buildings that are rented out, are good inflation hedges because the rental income pays for the taxes and the maintenance, allowing the owner to realize the full value of the appreciation on the price of the asset. You may also be able to generate a small income for daily expenses with a rental, depending on the market. One downside is the need to be on call to fix things or the need to pay a property manager, which will eliminate much of your profit.
The third type of assets that make a good inflation hedge is hard commodities such as gold and silver. These will definitely keep pace with inflation over long periods of time. In fact, if you wanted to give money to your great, great-grandchildren without needing anyone to watch over it, one of the best ways would be to buy some gold and have your family pass it from generation to generation, maybe buried in the back yard. The downside of gold is that it does have a premium attached at times when people get nervous about inflation or economic stability, such as in the late 1970’s or in the period around 2004-2008. If you buy at one of these times you risk seeing a decline and may need to wait decades for another speculative boom to push the price back up. It is therefore important to only buy when no one else is interested in gold or silver. There are also costs involved, such as renting a safe deposit box or paying for storage of your commodities.
The final, and probably the best hedge against inflation is to buy common stock in companies that are still growing. Because these companies will be able to charge more when the value of money declines, and because the value of their assets and capability to generate profits will increase with inflation, most of your portfolio that is used for growth should be in common stocks. When you are young and have an income from a job, you can allocate a fairly large portion of money to stocks that are growing very rapidly with little or no dividend. When you are in retirement, you need to mainly hold stock in large companies that still grow but are more stable because they have many product lines and the financial resources to weather economic downturns. These are the household names like Clorox and McDonald’s that create a steady profit stream. Buying into a fund that invests in large cap stocks is another way to invest in these companies.
Probably the best situation to be in is where you have enough money to invest about half of your money in income assets and half in growth assets where the income assets generate enough income to pay for expanses. You then slowly sell off some of the growth stocks and buy income assets as needed to keep your income up with inflation. In cases where the income assets don’t generate enough growth to pay for examples, you may need to sell stocks periodically to raise cash. Another possibility is to forego the income assets entirely and just keep enough cash on hand to pay for expenses for five years or so, allowing the rest of your money to grow in stocks.
In general, a balanced approach where you have different types of growth investments is best. Perhaps hold some land, a rental property or two, and a portfolio of common stocks. That way you will almost always have something performing well even when other assets aren’t do so well. Diversification is the secret to stability and reducing risk, which are important in retirement.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.