Personal Inflation

"Invest in inflation. It's the only thing going up."

- Will Rogers

I have a rather unfortunate habit of saving financial papers beyond their useful life. When it comes to financial documents of any sort, I'm clearly a packrat. It's not that I really want to keep so many papers, but rather that I don't want to take the time to sort out what is not needed and throw it out.

So I continued to save and save and now the four drawer filing cabinet is full, at which point I finally got the message that this has gone on for too long and needs to be confronted. Armed with a good shredder for 90% of the papers and a good scanner for the rest, I've been working through the cabinet for the past few days.

One of the more interesting finds has been a number of old receipts and other papers that show how much the prices of things have increased over a long period of time. This did not really surprise me, but the anecdotal examples from my own past drove the point home very clearly for me. Inflation is real. And very persistent. The current cost of some of the items is pretty amazing compared to the old receipts.

Here are some examples where I could make a fair comparison between an old receipt and the current cost of the exact same item:

• Apartment lease from early 90's. Cost: $705/month. Current cost: $1195/month.
  Annualized inflation rate = 3.35%
• Water bill from late 90's. Rate: $1.40/10K gl. Current rate: $1.55/10K gl.
  Annualized inflation rate = 1.28%
• Sewer bill from late 90's. Rate: $2.70/10K gl. Current rate: $3.66/10K gl.
  Annualized inflation rate = 3.88%
• Receipt for roll of 100 stamps for early 90's. Cost: $29/roll. Current rate: $41/roll.
  Annualized inflation rate = 2.34%
• College tuition bill from early 90's. Cost: $490/credit. Current cost: $1012/credit.
  Annualized inflation rate = 4.64%
• Studio piano receipt from early 90's. Cost: $3290. Current cost: $5900.
  Annualized inflation rate = 3.72%

I have said it before on this blog, but I'll say it again: Because it happens slowly, people tend to underestimate the long term effects of inflation. Even if you are clever and frugal, you will be affected by it. If your income is flat indefinitely, there is only so much substitution one can make until inflation will eventually force a reduction in living standards.

The average annualized inflation rate in the United States over the past century has been about 3.5%, and interestingly enough, a few anecdotal items from the filing cabinet seem to be in the same ballpark.

TIPS Rates Rising Fast

"By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens."

- John Maynard Keynes

I am going to buy TIPS at these levels. (TIPS = Treasury Inflation Protected Securities) My general rule of thumb is that when TIPS real rates are over 2.5%, they are of interest to me. (Pun intended.) TIPS have not been above 2.5% on a sustained basis for a long time, but they've really smashed through that level in the last several days and are now sitting at about 2.7%.

The historical record over the last century is that over time Treasury bills return less than 1% over inflation, and even long term Treasury bonds return less than 3% over inflation. (In some studies, long term Treasury bonds return closer to 2% over inflation.) Thus, a rate of 2.7% plus inflation seems quite good to me.

Many investors and academics consider TIPS to be a separate asset class. I concur with this view, although not merely based upon the empirical fact that TIPS have low correlation with many other asset classes. I believe you can decompose TIPS into two parts: a standard coupon bond plus what is essentially a forward contract on the consumer price index (CPI). One doesn't often find a security directly linked to a macroeconomic number like the CPI, so I agree that TIPS are a different animal than other assets.

You can find general quotes for TIPS rates here: http://www.bloomberg.com/markets/rates/index.html

Milestones and Thoughts on Inflation

"You cannot do a goal. Long-term planning and goal-setting must therefore be complemented by short-term planning. This kind of planning requires specifying activities. You can do an activity. Activities are steps along the way to a goal."

- Alan Lakein

I've reached two new milestones this week.

First, my net worth now exceeds $900K for the first time. This is roughly where I need to be to stay on plan.

Second, I now have the dubious honor of having my monthly property taxes on my residence exceed my monthly interest on my mortgage!

I had often heard comments from retired folks about how after many years their property taxes eventually exceeded their original principal and interest payments. Now I can clearly see how this happens! We have a fixed rate mortgage (15 year at 4.25%) so our P&I is fixed, but the property taxes keep slowly inching up. So I suppose eventually our property taxes will reach that level as well.

Frankly, the steady increase in property taxes was one of things that made me realize that I better not assume a constant level of income after retirement. One of the ramifications of being frugal is that since your discretionary spending is fairly low, a lot of your spending will go to items that you really need, but those items will still increase in cost over time.

If your budget is somewhat extravagant, then you might be able to live on a fixed income for quite a while, because you could gradually eliminate a lot of unnecessary expenses to compensate for inflation. However, if your budget is already tight, there is probably less that you can do to compensate for inflation.

Suppose that you are very frugal as you enter your retirement years. Your home is paid off, you cook your own meals, you drive an older car, you do your own yard work, and you don't purchase unnecessary items. You may not need a very large annual income in that case. But note that nearly all of your spending is going to necessities, so there will be no easy avenues for belt tightening. Slowly but steadily, all of your necessities, from property taxes to toilet paper, are going to increase in cost. Over a long period of time, this increase can be quite substantial.

If you're planning on a long retirement, you'd better make sure you've factored inflation into the picture. Don't assume your frugality can always counterbalance inflation. The more you've already been frugal with your spending in the past, the less maneuvering room you probably have to cut consumption any further in the future. Hence, there is a need to assume your retirement income must eventually rise to adjust for inflation and to keep your general standard of living intact.