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in life. You were responsible, raised children, worked hard for 40 years, saved and invested as much as you could in the stock market, and took good care of your health. You’re now 80 or 90 years old. Sadly, because of poor planning, fear, inflation, and debacles like the Enron disaster, you are now among the 95 percent of the popu-lation that is practically broke. If you’re lucky, your children or friends are caring for you. If you’re not, you’re on your own.
You may be thinking that it can’t be all that bad. Well, let’s see. Here’s a simple exercise to help determine how close to reality these fact might be. Most of us probably work in a field where we can look up the names and phone numbers of a few people that re-tired, say 5, 10, or even 20 years ago, from a job similar to yours. If you work in a bigger company, the human resources department may be able to help find some people to talk to. The task is to call these people and ask them how their retirement is going. Specifi-cally, ask how the company retirement plan is working. How much is Social Security helping them out? Is their retirement all it’s cracked up to be? Do they wish they would have made some differ-ent choices regarding investing along the way? Odds are, your former colleagues will give you a quick dose of their own brand of retirement reality.
If you have the courage to follow through with this exercise, we think you will fully understand why it’s time to get involved in running your own retirement program—a program independent of any Social Security benefits you’re counting on or your company pension plan.
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We’ve discussed inflation and its effects on your future. We will be showing you later how inflation can be your new best friend as a real estateinvestor. That is, ifyou learn how to harness its effects
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for your own good. For now we want to help you understand why inflation has such a devastating effect on most Americans, espe-cially those who are retired and on a fixed income.
So, what is inflation? In simple terms inflation is the loss in purchasing power of the money you have. Countless textbooks have been written about the subject, but for the average American, inflation can be defined as how much stuff that money in your wal-let will buy.
During our working years the effects of inflation are often min-imized by cost-of-living adjustments and other compensations from an employer. What’s more, as we grow in the workplace most of us strive to continually improve ourselves. As we receive raises in sal-ary or get new jobs that provide better pay, it appears as though we begin to spend at a slower rate. Therefore, the effects of inflation aren’t so noticeable. In these years, we settle into midlife, and we actually gain a false sense of security because our expenses seem to stabilize or, in some cases, even decrease. Once we retire, however, we won’t have that inflation-hedging job anymore. It’s at that point that we start using up our nest egg to support ourselves and this is where the truly harsh effects of inflation really begin to kick in.
Figure 1.1 is a chart of the historical inflation rates since 1975. These figures are unnerving, for when it comes time for you to re-tire, you might live long enough to see just as many swings in the rate.
For the majority of us, most of our retirement income willcome from money in various investments that hopefully are still earning a profit. The challenge facing us is to be sure we have a large pot of money and can earn enough to pay our expenses and protect any nest egg we’ve accumulated from the effects of inflation.
Inflation affects the cost of just about everything. If we make enough on our investments to pay our bills, then our nest egg is secure. If inflation outpaces our earnings, then we have to use up some of the principal to live on. As we use up the principal, the
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FIGURE 1.1 +,6725,&$/,1)/$7,215$7(6±
Year Inflation Rate
1975 16.94 1976 14.86 1977 16.70 1978 19.02 1979 13.29 1980 12.52 1981 18.92 1982 13.83 1983 13.79 1984 13.95 1985 13.80 1986 11.10 1987 14.43 1988 14.42 1989 14.65 1990 16.11 1991 13.06 1992 12.90 1993 12.75 1994 12.67 1995 12.54 1996 13.32 1997 11.70 1998 11.61 1999 12.68 2000 13.39 2001 12.86 2002 11.59
remaining balance declines and we need to take out even more to pay the bills. At some point the nest egg will be used up. This is the unfortunate situation of the 95 percent of retirees who are broke.
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There’s another component to this equation: taxes. Because your nest egg will be invested, you will need to pay taxes when you take out most of the earnings. These laws can be very complicated so it would be worth your time to seek out an expert to answer your specific questions. Here, however, our goal is to show you the effect of inflation and taxes on what you really earn on those investments.
Just as inflation can fluctuate, so does the return you can expect on your investments. As we write this in early 2002, most banks are paying near 2 percent or lower on certificates of deposit (CDs). This doesn’t even keep pace with inflation.
To illustrate, we’ll use the following example: For inflation we’ll use 3 percent, for your return on investments we’ll use 7 per-cent, and for taxes we’ll use 28 percent. What we’re looking for is actual growth in the purchasing power of your nest egg or, at least, the ability to protect the principal balance. We’ll assume you have $50,000 earning 7 percent.
The bottom-line numbers look like this:
Nest Egg $50,000 Rate of Return ´ 7% Earnings $ 3,500
Then multiply the earnings by the tax bracket to determine how much tax is owed:
Earnings $53,500 Tax Rate ´ 28% Tax Owed $50,980
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To determine the loss in purchasing power because of infla-tion, multiply the nest egg by the inflation rate:
Nest Egg $50,000 Inflation ´ 3% Loss in Purchasing Power $51,500
In order to determine the actual rate of return, subtract your taxes owed and your loss in purchasing power from your earnings:
Earnings Less Taxes
Less Loss in Purchasing Power
Real Return
$3,500 – $1,980 – $1,500
$1,020
Finally, to determine your percentage return on your invest-ment, divide the return by the nest egg:
$1,020 (Return) ÷ $50,000 (Nest Egg) = 2.04%
As you can see, a 2.04 percent return isn’t a very comforting margin of error, especially when it comes to protecting the nest egg that will support you and your family for the rest of your lives.
We’re sure you have watched inflation go up several times in your life and marveled at how slowly the yields on your investments caught up to the increases. It’s at those times that retired Ameri-cans either dip into their nest eggs to live or are forced to seriously cut back on their current standards of living to preserve them.
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A frequent topic of conversation when discussing retirement is Social Security. Most people joke about Social Security, nervously
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