The Cost of Inflation
Inflation is a critical issue in financial planning because it is essentially a tax on your future earnings. Unfortunately, investors have essentially no control over the rate of inflation, since it is set by the complex interaction of market forces, monetary policy and governmental fiscal policy.
At the most basic level, the inflation rate is the “hurdle rate” that investments will need to overcome to generate a positive real return. Otherwise, the purchasing power of the money associated with the investment will be less in the future. Stated another way, the nominal rate of return (i.e. the stated interest rate for bank accounts and bonds) needs to be greater than the inflation rate.
Note: The real rate return on any investment can be calculated as (nominal rate – inflation rate) / (1+ inflation rate)
Source: Bureau of Labor Statistics: CPI – All Urban Consumers, all items less food and energy: data.bls.gov/pdq/SurveyOutputServlet
Historical and Target Inflation:
Inflation rates have been relatively stable since 1994, averaging 2.2% per year. The U.S. Federal Reserve has announced a target inflation rate of 2.5%, meaning that they will attempt to manage the U.S. money supply so that 2.5% will be the average long-term rate over the foreseeable future. For planning purposes, a 2.0% to 2.5% inflation rate is used by most financial advisors.
Typical Nominal Rates of Return on Investments
|Investment “Vehicle”||Typical Nominal Rate of Return (from July 2018)|
|Local Bank Checking account||less than 0.2%|
|Internet Bank Savings account||1.5%|
|1-year CD (Certificate of Deposit)||2.3%|
|Municipal Bond: 10 year, AA rated||2.6%|
|Corporate Bonds: Long term (>10 years)||4.5%|
|Large Company (S&P 500) Stock Fund||Highly Variable, but 8% average, historically|
Important note: Rates of Return change! The above rates are meant to be indicative of the relative rates that are generally available and are for illustrative purposes only.
Higher rates of return come with greater risk.
The increasing rates of return as you move down the table above are associated with greater financial risk. The first three investment vehicles in the table are FDIC insured up to $250,000 per account. Bonds with long maturities have a fixed nominal rate of return (their coupon rate), but they have greater risk than a 1-year CD because of the risk that inflation will increase during the 10-year period of the bond, making the real rate of return less. Although stocks have historically achieved rates of return significantly above inflation, their year-to-year (and even day-to-day) return is highly variable.
Key Money Matters Points:
- Don’t leave large cash balances in your checking or savings account: The above table shows that current rates paid on checking and savings accounts do not keep up with inflation, which means the money that you are keeping in these types of accounts is losing purchasing power every year. This has been true since 2008 when the credit upheaval of the Great Recession significantly lowered the rate of return on these accounts. Before that, they had historically been able to approximately meet the rate of inflation. Although checking accounts are still generally necessary for paying regular expenses, most advisors do not advocate holding more than 3 months worth of your expenses in a checking or savings account.
Money you will need for expenses beyond 3 months can be held in a money-market mutual fund or rolling 1 year CDs which both have yields closer to the rate of inflation. A broker, a banker, or a financial advisor can help set up these types of investments.
- Actual Taxes Make Beating Inflation even more difficult: Federal tax is due on nearly all investment returns except municipal bonds (the 4th line in the table above). So the actual purchasing power of your future earnings is reduced further by your tax rate. For example, if your marginal tax rate is 22% (which is the rate for individuals with taxable income up to $82,500/year and couples up to $165,000/year) then the actual, after-tax rate of return on a 1-year CD with a 2.3% interest rate is only 1.79% [=2.3%*(1-.22)], which likely drops it below the rate of inflation. Stock dividends and capital gains are taxed at a different, capital gains tax rate (which is lower than marginal federal income tax rates).
The main advantage of putting investment assets in IRAs or other tax advantaged accounts is the avoidance of this annual tax “drag” on your investment returns.
The Bottom Line:
Maintaining the purchasing power of your invested money has become more challenging in the past 10 years because of historically low checking, CD and bond rates of return. Most financial advisors have encouraged their clients to take on greater risk for their longer-term investments, but the level of risk that is tolerable for each client is personal. As with many financial decisions there is a trade-off between financial success and peace of mind.
John Krehbiel is an independent, fee-for-advice, financial planner who specializes in helping busy couples and tech professionals in Brevard County, Florida. Krehbiel Financial LLC is a Registered Investment Advisor in the State of Florida and Texas. The information in this article should not be relied upon for the purposes of transacting securities or other investments. You should consult with a financial advisor or other professional to determine what may be best for your individual needs.