Racine Journal Times, WorkLife Section, November 18, 2007

The Dirty 'I' Word

If you had to chart a course from Racine to Milwaukee, you wouldn’t be concerned if you veered off your planned route by, say, one inch for every mile of your journey because you’d still make it to Milwaukee.  But what if you veered off from your route by that same inch per mile when traveling from Earth to Neptune – 2.7 billion miles away – and you only had enough fuel and supplies to last for the duration of your planned journey?  Without a friendly alien willing to save the day, you’d be in serious trouble.

Minor flaws, left uncorrected, create not-so-minor results when exaggerated by time or distance. That’s why I felt compelled, about a year ago, to send an e-mail to the editor of a popular personal finance magazine. I’ve enjoyed reading this magazine for many years, as the articles are, by and large, informative and reliable. The article in question, however, offered faulty advice on the amount of money one should accumulate, by retirement, in order to support the amount needed to live on during your fall and winter years.

The target amount they errantly advised their readers to save for retirement is twenty times your current annual spending needs. According to their formula, you would need $1 million to support $50,000 of current annual spending. To their credit, the authors did state that their rule of thumb is a crude estimation. I couldn’t agree more. Why? The problem I pointed out to the magazine’s editor was that this rule of thumb doesn’t factor in the dirty “I” word: Inflation.

Ignoring inflation can cost you

$1.0 million may be enough to support a $50,000 annual withdrawal for those retiring right now, but for anyone retiring at a later date, that target ($1.0 million) has to be bumped up at an exponential rate, rising faster the further you go out in the future. Assuming an annual inflation rate of 3.2%, in five years, you’ll need $1.2 million (23.4 x spending) to support that same $50,000 withdrawal; in ten years, $1.4 million (27.4 x spending); in twenty years, $1.9 million (37.6 x spending).

Ignoring 3.2% each year seems like a minor flaw, but just like one inch off course per mile is minor if you’re the astronaut traveling to Neptune, the end result won’t feel minor if you have to accept a lifestyle that’s only 53% of what you planned for retirement. That’s one reason why, as I stated in last month’s article, following rules of thumb can be problematic.

What's your 'real return'?

Another problem caused by inflation when making projections far into the future is when, as we saw in the 1970s, economic and geo-political conditions send a burst of oxygen over burning embers of inflation. Without providing for some room for error, those who retired just prior to or in the 1970s felt the pinch of higher prices across the board – food, energy, medical care and housing. Sound familiar?

An even worse scenario, which we could be facing at the moment, is when you have a mix of inflationary pressures, dampened economic growth and Wall Street losing its appetite for risk. Given that tasty cocktail, overextended financial assets have a hard time cranking out healthy real returns. What are real returns? It’s the return you receive on your investments after subtracting inflation. That nifty number is what really matters because it determines how much wealth you’ll truly accumulate, and the type of lifestyle you’ll lead when retired.

The dirty “I” word causes more than one central banker to lose sleep, and with good reason. That’s why the Fed has recently warned that, due to inflationary pressures, it doesn’t have as much room as it would like for further interest rate cuts, despite stronger economic headwinds. I don’t envy Bernanke and his crew, as they’re in one big pickle.

Allow room for error

One of the best ways to deal with an uncertain future is to allow room for error. Countless businesses have failed and families destroyed, because those making decisions today – which ultimately affects tomorrow – made unrealistic projections with little or no room for error.

How can you allow room for error? At the very least, spend your time, energy and resources on those factors you can control, and none on those things outside of your control. For example, be sure to establish an emergency fund, which translates to less dependence on credit cards when unexpected events, like your washer breaking down or the loss of your job, occur. Living well within your means also allows room for error. For those 40 and younger, less dependence on government entitlement programs, such as social security, and more dependence on your own savings will provide more cushion in the event those programs are incapable of fulfilling their obligations to your generation. For your investment portfolio, room for error is provided by greater diversification, a well-rounded asset allocation and downside protection. Father Time also gives you some cushion, so it’s never too early to throw out that procrastination suit.

Life is messy. Nothing ever goes according to plan. Allow room for error and you’ll increase the odds that, despite the unexpected, you’ll stay on course and reach your final destination with very few bumps along the way.

Michelle Ouzounian, CMFC, is the founder and President of Verity Investment Counsel, Inc. (www.verityinvcounsel.com), a fee-only, independent registered investment advisory firm in Racine. Michelle can be reached at 262-898-8400, or m.ouzounian@verityinvcounsel.com.

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This article contains the opinions of the author, but not necessarily those of Verity Investment Counsel, Inc.  Such opinions are subject to change without notice.  This article is provided for educational purposes only.  The information contained herein does not suggest or imply and should not be construed, in any manner, a guarantee of future performance and/or investment advice.  Information contained in this article was obtained from sources believed to be reliable, but not guaranteed.  No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Verity Investment Counsel, Inc.